What Is So Hard About Fractional Reserve Banking for Economists?
I am being deliberately cheeky in my post title… But I think a quote on banking reserves from Alchian that David R. Henderson gives (without him necessarily endorsing it in the original context) is not the same as the other two things to which it is supposedly analogous. Let me just give David’s whole post:
“To rely upon a reserve requirement for the meeting of cash-withdrawal demands of banks’ customers is analogous to trying to protect a community from fire by requiring that a large water tank be kept full at all times: the water is useless in case of emergency if it cannot be drawn from the tank.”
Armen A. Alchian and Willam R. Allen give this unsourced quote on p. 708 of the first edition of their modern classic, University Economics. BTW, I lost my copy of the third edition in my 2007 fire and my friend, Gloria Valentine, Milton Friedman’s long-time assistant, gave me Milton’s autographed copy. It’s inscribed, “To Milton, Herein–somethings old, somethings new, somethings good–borrowed straight from you. Armie.”
I was reminded of this when I read Russ Roberts’ post in which he quoted from an article in The Economist. For days, the Japanese government kept to its policy of requiring that oil refiners keep a minimum of 70 days’ supply in reserve. Specifically:
When the crisis hit, there was a law on the books requiring energy companies to keep 70 days of petrol in reserve. This was quickly lowered by three days, but that did not help. And there is the outrage. It was not until March 21st, ten days after the crisis, that the limit was lowered to 45 days.
See the problem?
Yes, I see the problem with mandated reserves on water and petrol, but not on bank deposits. (At least, not for the reasons David is citing; I don’t think the government should have anything to do with banks one way or the other.)
If banks as a rule keep 100% of their customers’ cash in the vault after they deposit it, that doesn’t mean–as Alchian implies–that there will be no cash in an emergency when their customers want to withdraw it. On the contrary, it guarantees that there will be cash in an emergency when their customers want to withdraw it.
Specifically, Alchian’s argument fails because when a customer withdraws his cash, the bank’s reserve requirement (in absolute terms) goes down. In other words, the government/Fed isn’t saying to banks, “Keep $100 billion in the vault at all times.” No, they are saying, “Keep 10% of deposits in the vault at all times.” Those are totally different things, as you can easily see if you bump it up to 100% reserves.
P.S. Yes I know David has leveled a challenge against me. But, uh, I have to go cut the lawn…
(I will try to answer him after I think about it some more.)
Henderson is right.
That required reserves fall with deposits must means that rather than 100% of the reserves being wasted, 1 minus the required reserve ratio are wasted.
It could well be that starting with 100% reserves is steering your wrong.
Start with 0% reserves. Figure out banking. Then think about why banks might choose to hold reserves.
It really is enlightening.
Hey, it might also help to start with banks that provide no monetary services– C.D.s Creating liquidity, why they might hold money balances of some sort, and so on.
Then, think about banks creating debt instruements that are very good substitutes for the medium of exchange–even approximating perfect substitutes, or even superior in some ways…
At some point, you beging to see that starting with the money warehouse that decides to lend some of its reserves really confused things.
Anon, do your arguments apply to coat-check tickets at a theater or restaurant? If the government says it would be fraud for the restaurant to sell the patrons’ coats on e-bay, does that leave the community vulnerable to a snowstorm where we might run out of coats?
There is the problem of fungibility and interchangeability…a one-ounce coin (or a line of code in a bank computer) is largely interchangeable and fungible. It’s not, per Wilson’s example, composed of ten percent junk I found before I tricked the bank into accepting it. A coat, on the other hand, is not like a coin in this regard. Not just any coat will do to replace the one I gave up at the theater – there is an explicit expectation that the exact coat deposited is the one to be returned. In fact, I expect every last moldy crumb of bread in the left breast pocket and the liner notes from Can’t Buy A Thrill to still be there when I get it back and if they aren’t, I’ll raise three circles of Hell in that theater lobby! I wanted to feed the birds and snicker at the completely flat note answering Jeff Baxter’s question about the secretary at ABC Dunhill!
If this were not the case, the analogy would hold. And I’d be reading the liner notes to Civilization Phaze III.
“At some point, you beging to see that starting with the money warehouse that decides to lend some of its reserves really confused things.” –Anonymous
I think this is a good point. Unless historically accurate (I don’t know one way or the other) Rothbard’s thought experiment is not very helpful. Unless fractional reserve banking actually started by warehouse keepers loaning out some of the inventory in an extra-contractual fashion – in which case it doesn’t matter that it was money, it was still fraud – it really is a bad place to start. I am making the qualification on the tentative assumption that it really didn’t begin like that, but I have no basis to say so.
You guys are making this way too complicated. Here is the original quote (which actually Alchian and co-author were quoting, but apparently with approval):
“To rely upon a reserve requirement for the meeting of cash-withdrawal demands of banks’ customers is analogous to trying to protect a community from fire by requiring that a large water tank be kept full at all times: the water is useless in case of emergency if it cannot be drawn from the tank.”
So I’m saying, no, that’s not analogous at all. Let’s say the government/Fed did the “worst” possible thing, and mandated that the banks keep 100% reserves. According to the quotation, for a second you think, “Oh my gosh! That means the cusomters aren’t allowed to withdraw any of their money in a crisis!!”
But wait, it actually means the customers can be certain that the bank will have their money in a crisis.
Go the other way. Suppose the government/Fed mandated that the bank keep 0% reserves. Now there is a crisis. Oops, the customers are guaranteed to get none of their money back.
It’s a weird analogy where the opposite thing happens at both ends of the spectrum, isn’t it? But you guys are saying the analysis flips when the reserve rate is in between 0 and 100%?
(I know you’re not saying that, I get what you’re saying. But look at what I am saying: that is not analogous to water or petrol reserves at all, and again, it’s because cash reserves on banks have to do with percentages on customer deposit balances, not with reference to a specific stockpile of money.)
“So I’m saying, no, that’s not analogous at all. Let’s say the government/Fed did the “worst” possible thing, and mandated that the banks keep 100% reserves”
Why does this even matter? A bank will short of reserves until the day they are required to meet the requirement. They go the inner bank market, meet the requirement, then move on. End of story. You do realize the reserve requirement is not a daily requirement, right?
Sorry folks. But FRB the way you think of it is dead. Has been for a while. You’re fighting the boogie man.
You’re confusing the operational practices of banks on a basis of inflation and required reserves already existing, with the notion that these operational practices are therefore fundamental and not secondary/derivative.
The reason why banks do not engage in frb according to reserve requirements in the operational sense is because the Fed accommodates the banks afterwards by inflating enough reserves into the overnight interbank (fed funds) market. Banks issue loans in the operational sense by considering their capital assets. However the reserve requirement is still the fundamental driver of credit expansion.
Observe. Suppose there is a 10% reserve requirement on all checking related accounts, and suppose that the Fed does not inflate into the overnight (fed funds) loan market. What will happen? Well, banks will expand credit operationally by considering their capital assets at first. They will expand credit ex nihilo until the risks of loss are too great to justify further credit expansion. This could result in an effective reserve ratio of more than 10%, or it could generate a 10% reserve. Suppose one day a bank held less than 10% reserve. It is thus deficient in required reserves. Typically what a bank will do is go into the overnight loan market and borrow from other banks that have enough excess reserves to lend. But what happens when enough banks are at or less than 10% required reserve such that there isn’t enough excess reserves in the loan market for all the banks who hold below the required minimum to satisfy the minimum reserve requirement? They will have to start selling their assets for cash in the asset market. Since this process will not necessarily result in additional bank reserves (since selling assets in the US market will simply move whatever quantity of money around from bank to bank, and not increase total bank reserves, however total reserves can increase if assets are sold to international buyers who hold US dollars in non-US banks, but for the sake of simplicity we can ignore this because it will only delay the process of asset selling in a scenario of reserve deficient banks selling assets in order to achieve minimum reserve requirements, we will not lose generality), it means that banks will be eventually be prevented from making further loans according to the reserve ratio, not their capital ratio.
The reason why banks in the US never reach this point is because of two main reasons. One, the government does not even enforce the minimum reserve requirement. No bank is legally fined or nationalized for having deficient reserves. As long as a bank can pay its bills, the government essentially turns a blind eye. Two, the Fed always accommodates the banks by inflating the banking system’s reserves. They traditionally do this at a rate that generates a targeted overnight interest rate, however since at least 2008, they have done this by more unconventional means like worthless asset purchases, direct loans to banks outside of the traditional discount window approach, and even by granting loans to select private businesses as well as foreign central banks and governments.
Because of the Fed always accommodating the banks by inflating the overnight market by enough to generate a below market interest rate, banks are not operationally constrained by the reserve requirement. But fundamentally they still are, as is evidenced by what happens when the Fed stops inflating and banks continue to inflate nonetheless. At some point, they will hit their reserve requirement, and assuming the government will enforce it, the banks will be constrained from making further loans because there is not enough money to borrow in the overnight market to facilitate further credit expansion.
Finally, you’re also wrong when you claimed that the reserve requirement is not a daily requirement. It is a daily requirement, at least on paper according to law. It is why the fed funds market is also called the “overnight” market. Banks traditionally borrowed in this overnight market to satisfy their daily reserve requirements. Of course things have changed since then, and banks no longer make loans operationally according to the reserve requirement, nor is it even enforced, but fundamentally (in the long term) and legally (at least on paper) the daily requirement and the reserve ration still exists.
Bob:
Surprised that you jumped into some coat check story about fraud. You really take that seriously?
I thought you said you didnt’ think the government should be involved.
Suppose I put my coat in storage and as part of the deal, they ask me when I want it back. They ship it
away and it will take some time to get it ready on the other end. So, I tell them some date next fall. Can they
rent out my coat now? The ” I can go to the cloakroom and get my coat when I want it” deal vs. “I have told them
they have it for some period of time” deal, has nothing to do whether they can rent it out.
Suppose there is a business where I rent my mink coat to a company and then they rent it out. Suppose it is by the month. Rich people short of cash use this. Anyway, to get more business, the operator says that if some important social event suddenly arises and you need a mink coat, you can pick one just as good as your’s and take it. The Rothbardian dogma is that this extra service makes the entire operation fraud. That his disciples have made it into an issue of metaphysics is even more incredible.
Of course, i am sure Rothbard would not worry about it. This is _all_ about his view that fractional reserve banking creates massive negative externalities, but his natural law moral philosophy makes those irrelevant and so there are ever more strained efforts to claim that this must be fraud. For me, the only remaining question is how much of this is just a “Noble Lie?”
Anyway, the reason banks have promises to pay on demand is because governments made them do it because
hard money advocates want to make banks hold more gold. We know that banks actually write contracts that require notice for withdrawal of cash or allow options, which they hardly ever utilize. And their customers accept this. It is the hard money advocates that intervene to prohibit these contracts to increase the penalty for running out of gold.
As for your claim and the “worst” regulation of reserves, it isn’t too hard to understand..
As I explained above, with zero percent reserves, none of the required reserve is wasted because there is none. With a 1% reserve requrement, 99% of the required reserve is wasted. WIth 10%, 90% is wasted. With 20%, 80% is wasted. When, you hit 50%, 50% is wasted. At 60%, 40% is wasted. At 99%, 1% is wasted. At a 100%, 0% of the required reserves are wasted.
If the reserve requirement scheme is tightly binding, then the actual _reserves_ are those in addition to required.reseves. That is what serves as the reserve to meet differences between receipts and payments.
In the U.S., reserve requiremetns aren’t tightly binding. Required reserves today depend on what is needed to meet an average of deposits in the past. So, a banks reserves can be run down to meet payment needs today It just must have them extra high later so the average of reserves equals the required fraction of the average of deposits. (The schedule of reserve requiremetns is on the Fed website.) A bank has a couple of days to fix it, and so plenty of time to sell T-bills or purchase Federal Funds. Or, of course, get a primary credit loan from the Fed.
And, of course, banks can always change what part of deposits are reported as transactions deposits. At least that seems to be an implication of sweep accounts. Reserve requirements are really pretty empty these days.
Suppose instead that banks are understood to be repositories of gold subject to being seized by the goverenment with the gold being used to hire mercenaries. A bank with a 3% reserve would have little to take when it is suddenly seized. The bank with 100% reserves would have the most to take. From that perspective, using currency to cover temporary imablances beween receipts and payments would be irrelevant to the true purpose of “reserves”
In my view, support for 100% reserves is all about making sure that the amount of gold available for the King to seize is maximized. That is exactly why early modern monarch’s banned the money changer banking system that developed in the Middle ages. Right.. it was all about protecting the merchants from fraud by those shady Italian money changers. That the wealth of the Kingdom seemed to be nothing more than entries in some books by some Italians who could return to Italy and that Swiss mercenaries weren’t taking anyway had nothing to do with it. Oh… you all don’t want to carry around Treasure chests? You can store your money at the Royal Treasury…..Oh, we will have a special government Bank of Ansterdam. We will store all your gold right there. Sound money.
And, of course, reserve requirements today is about increasing the demand for base money, and so the amount of government bonds that can be sold by the Treasury with the interest being paid to the Fed and then kicked back to the Treasury can also be increased. To repeat my point above, sweep accounts make this pretty much a dead letter. Those in charge, apparently, don’t want to collect this tax. Perhaps it has to do with compeittion with foreign financial centers, the well being of the economy of New York City, and the political influence of commerical bankers.
“you can pick one just as good as your’s and take it”
Is this the case with FSB?
Telling the coat-check place they can hold onto your coat and rent it out of X months would be analogous to a CD/time depost, *not* a demand deposit. The latter tries to claim that you can pick up the coat whenever you feel like it, while at the same time knowingly not being able to honor that.
I thought you said you didnt’ think the government should be involved.
One can be against murder, rape, and fraud and be against the government declaring itself to be the monopoly enforcer against these practices. It is wrong to claim that only government can stop frb.
Suppose I put my coat in storage and as part of the deal, they ask me when I want it back. They ship it away and it will take some time to get it ready on the other end. So, I tell them some date next fall. Can they rent out my coat now? The ” I can go to the cloakroom and get my coat when I want it” deal vs. “I have told them
they have it for some period of time” deal, has nothing to do whether they can rent it out.
If you give them your coat with the intention of them keeping it available for you at all times for your withdrawal, then it would be fraudulent misappropriation for them to loan it out because that coat remains your property. They are merely custodians of your coat.
If you did want them to loan it out, for a set time period, then it would not be fraud for them to loan it out because the coat would become their property for that time period, which means they can loan it out and grant ownership to another.
Suppose there is a business where I rent my mink coat to a company and then they rent it out. Suppose it is by the month. Rich people short of cash use this. Anyway, to get more business, the operator says that if some important social event suddenly arises and you need a mink coat, you can pick one just as good as your’s and take it. The Rothbardian dogma is that this extra service makes the entire operation fraud. That his disciples have made it into an issue of metaphysics is even more incredible.
Your dogma that other people’s coats have to be loaned out to others or else people will be unable to acquire coats when they need one is like saying people are entitled to coats, period, and that if more people are granted ownership of other people’s coats, then there is no fraud. People can wear a coat when they want to wear one, so us Rothbardian dogmatists should not complain.
According to you frb fraud advocates, the coat check business has to be allowed to grant ownership of the same coat to more than one person if they want, and thus impose risk of loss on at least some of the owners of coats, should the coat check business go bankrupt. The Rothbard “dogma” is not dogma. It is just taking the traditional property rights framework and applying it to money. You frb dogmatists believe that traditional property rights framework should be applied to everything except money. That is arbitrary and absurd.
Just because a coat check business can enable more people to wear coats than would otherwise be the case by granting multiple ownership claims of coats to more than one person, does not mean that there is no fraud taking place. There is fraud, because the number of ownership titles exceeds the number of owners. Only when the number of owners is equal to the number of ownership titles is fraud absent. The fraud you advocate is not made explicit unless the coat check company goes bankrupt, where those owners lucky enough to get their coats back take physical possession of their property, whereas every other owner is told that the coat check company does not have their coat. This is why central banking was perceived as necessary in the first place. It was to bail out fraudulent banks that overextended ex nihilo credit. It was to avert the realization of this explicit fraud and make the fraud more difficult to understand, where the costs are transferred to everyone who holds dollars.
Bank bankruptcies and defaulting on demand deposit obligations are very visible and would make the public at large understand that banks misappropriate their money. But with central banking, banks can inflate together in unison, and enable banks to inflate more without defaulting on their explicit promise to pay. FDIC insurance has also made the public at large believe that their money is safe, and nominally it is safe, but in purchasing power it is not. So the frb fraud gets translated into rising prices the costs of which are imposed on everyone who holds dollars. Instead of people experiencing losses through the banks saying they don’t have their client’s money, they instead experience the costs through rising prices, which allows people like you to have another source for confusing innocent people and convincing them that frb fraud really isn’t fraud because superficially it appears as though their money is as safe as it would be if the banks did not loan the money. Central banking and FDIC would not have been perceived as necessary if frb fraud did not take place. Only because frb fraud is permitted and encouraged by government (as well as preventing by violence the private defense agencies from enforcing a ban on frb themselves at their client’s behest) is central banking and FDIC perceived as necessary.
Of course central banking, while enabling banks to keep the fraud going for longer, can only keep the fraud going for a delimited time more, and only imperfectly at that, which is why FDIC insurance was perceived as necessary. But the effects of FDIC is also delimited, which is why gold bullion investment still has a price.
The issue of property rights is in fact a metaphysical issue, because ownership of property is exclusionary to individual parties (individual person or joint ownership) by nature. Ownership of property means the individual party, and no one else, owns that property. Fractional reserve banking is an attempt at violating this metaphysical necessity, which is why frb leads to bank bankruptcies, central banking, FDIC, and the business cycle and thus recessions/depressions. Attempts to violate such metaphysical necessities is the reason why problems are created.
Of course, i am sure Rothbard would not worry about it. This is _all_ about his view that fractional reserve banking creates massive negative externalities, but his natural law moral philosophy makes those irrelevant and so there are ever more strained efforts to claim that this must be fraud. For me, the only remaining question is how much of this is just a “Noble Lie?”
Not at all. Natural law philosophy and negative effects of violating actions consistent with natural law philosophy are very much interrelated and mutually reinforcing. It is not an either/or scenario. Refuting frb using one framework does not make the other framework irrelevant to refuting frb. Rothbard would have argued to you, and did argue in his writings, that negative effects are a direct consequence of attempting to violate natural law. That is why he held that any social system can be judged against natural law theory. Rothbard did not hold that criticism of frb is only about its negative effects, even though that would be enough to ban it. He also argued that frb violates traditional property rights.
The shoe is on the other foot. It is those who attempt to justify frb who strain to defend it after each subsequent defense of frb is refuted as fallacious. No attempt to defend frb has ever succeeded. Every single argument thus far has been exposed as fallacious.
Anyway, the reason banks have promises to pay on demand is because governments made them do it because hard money advocates want to make banks hold more gold.
What ridiculous reactionary ex post rationalization. No, the reason why governments enforce a “pay on demand” framework (which is not even the case with frb, central banking, and FDIC) instead of a property rights framework, is because the banks independently want to earn profits on otherwise “idle money”, and governments accept this because it allows government to be a borrower of other people’s money as well. Add to the mix that bankers are large political influences because they are a source of money for government and you can understand why frb is allowed and encouraged by government. This has been the case for hundreds of years. As long as government exists, the need for government financing will exist, and that puts banks as number one on the government’s list of control. This is why governmental control of money exists the world over. A government that does not control money is a government that is controlled by the people. A government that controls money is a government that controls the people.
We know that banks actually write contracts that require notice for withdrawal of cash or allow options, which they hardly ever utilize. And their customers accept this. It is the hard money advocates that intervene to prohibit these contracts to increase the penalty for running out of gold.
Banks and frb apologetic customers are not the only relevant parties to frb. It is banks and frb apologetic clients who intervene to prohibit fraudulent behavior, the fraud of which gets transferred onto everyone who deals with government mandated paper money. A demand deposit customer who “allows” their bank to loan that demand deposit money out and thus grant demand deposit money to others are just transferring the fraud and the destructive economic consequences to other parties. For it results in more than one property claim to the same property. Either the merchants who accept claims to money that does not exist, or to other unsuspecting demand deposit clients who are granted ownership of money that is actually the property of others, are the main victims. Even those who don’t even deposit their money in traditional deposit accounts that are subject to frb are also victimized, through the effects of the business cycle that is the result of frb. The creation of these latter victims are enough to ban frb as well.
A recent poll in the UK showed that over 70% of the population believes that their banks actually have their cash on hand. You can play blame the victim if you want, but when time and time again the economy booms and busts, affecting those who do not deposit their money in frb accounts, and those who do not take out bank loans, when time and time again banks go bankrupt, thus leaving demand deposit holders with nothing (or less purchasing power with central banking and FDIC), and when time and time again banks acquire bailouts at US taxpayer’s and US dollar holder’s expense, which you can be against if you want but your position won’t stop it as long as you preach that frb is not fraudulent and the fraud enablers are guilt driven into reacting to fix their own mess, combined with the fact that granting more than one ownership claim to the same property is inherently fraudulent, let alone generating the destructive business cycle, then logic and economic science dictate that frb should be banned.
As for your claim and the “worst” regulation of reserves, it isn’t too hard to understand..
As I explained above, with zero percent reserves, none of the required reserve is wasted because there is none. With a 1% reserve requrement, 99% of the required reserve is wasted. WIth 10%, 90% is wasted. With 20%, 80% is wasted. When, you hit 50%, 50% is wasted. At 60%, 40% is wasted. At 99%, 1% is wasted. At a 100%, 0% of the required reserves are wasted.
If the reserve requirement scheme is tightly binding, then the actual _reserves_ are those in addition to required.reseves. That is what serves as the reserve to meet differences between receipts and payments.
Holding more reserves than the “less than 100%” required minimum also mitigates the extent of business cycle fluctuations, and the extent of fraud. You’re just talking about the technicalities of how banks can stay operational despite frb, much like advising a coat check business how to stay in operation despite granting ownership claims for the same coat to more than one independent party. It’s allegedly not fraud if the coat check business can satisfy coat withdrawals on request in theory, and if they can’t in practice, then too bad so sad, the fault is with the coat check business that granted too many ownership claims to the same coats, and with the coat customers who agreed to give their coat to the coat check business. For everyone else who are either coat check customers and completely unaware of the coat check business practices (70% of the UK for example), or who are not even coat check customers, but coat burial customers, who nevertheless experience the negative effects of frb coat check practices, through the frb coat check business cycle, well, too bad for all these people, because dammit, frb is okay.
In the U.S., reserve requiremetns aren’t tightly binding. Required reserves today depend on what is needed to meet an average of deposits in the past. So, a banks reserves can be run down to meet payment needs today It just must have them extra high later so the average of reserves equals the required fraction of the average of deposits. (The schedule of reserve requiremetns is on the Fed website.) A bank has a couple of days to fix it, and so plenty of time to sell T-bills or purchase Federal Funds. Or, of course, get a primary credit loan from the Fed.
And, of course, banks can always change what part of deposits are reported as transactions deposits. At least that seems to be an implication of sweep accounts
FRB banks can only depend on Federal Funds if the Fed keeps inflating. At some point, without central banks inflating bank reserves, continuously expanding frb banks will find that there is not enough fed funds available to finance their withdrawal and expense obligations. At some point without central banks, frb banks will face bankruptcy because frb generates the business cycle, and eventual depression and “liquidity crunch.” At this point, bank failures will reduce the quantity of money and volume of spending even more, which will then reduce profitability even more, which will result in more bank failures and a further reduction in the quantity of money. This process will continue until the quantity of money cannot be reduced any more because the money that remains will be all, or almost all, real “hard” currency and not fiduciary money (frb credit expansion money unbacked by anything tangible). At that point, further bank failure and further debt default will not reduce the quantity of money because there will be no more money, or very little money, that is frb based. In other words, a free market in money will naturally “attack” and be antagonistic towards frb. This is why the government, banks (and many ignorant economists like you) perceive it necessary to have central banking, FDIC, and everything else that treats the destructive symptoms of frb and not the root of frb itself. Economists like you want to have their cake and eat it too. You want demand deposits to be loans as well. You don’t want central banking or FDIC, but these things are inevitable with frb because by viewing frb as not fraud and not the cause of business cycles, it leads government and economists to treat recessions as inherent in the market process (voluntary trade) itself, which makes it seem like government is the solution to the very problems it itself encouraged and/or mandated, and frb is claimed as not fraudulent and not economically destructive.
Reserve requirements are really pretty empty these days.
And wouldn’t you know it? Economic fluctuations are becoming more and more pronounced these days as well. We are now having more periods of seemingly incredible growth, followed by periods of deeper and more painful recession. Without central banking and without FDIC, and with frb, the periods of growth (and recession) will be more frequent and shallower in height (and depth). But the business cycle and the fraud will persist. If we are to completely eradicate the business cycle, then not only does central banking and FDIC have to end, but frb as well. Ignorant and crude economists like you believe the business cycle is inherent in the free market, because you refuse to accept the reality of frb, the reasons of which are quite frankly absurd and are the rantings of monetary cranks.
Suppose instead that banks are understood to be repositories of gold subject to being seized by the goverenment with the gold being used to hire mercenaries. A bank with a 3% reserve would have little to take when it is suddenly seized. The bank with 100% reserves would have the most to take. From that perspective, using currency to cover temporary imablances beween receipts and payments would be irrelevant to the true purpose of “reserves”.
In my view, support for 100% reserves is all about making sure that the amount of gold available for the King to seize is maximized. That is exactly why early modern monarch’s banned the money changer banking system that developed in the Middle ages. Right.. it was all about protecting the merchants from fraud by those shady Italian money changers. That the wealth of the Kingdom seemed to be nothing more than entries in some books by some Italians who could return to Italy and that Swiss mercenaries weren’t taking anyway had nothing to do with it. Oh… you all don’t want to carry around Treasure chests? You can store your money at the Royal Treasury…..Oh, we will have a special government Bank of Ansterdam. We will store all your gold right there. Sound money.
This theory is in my view the ONLY plausible and economically sound argument that could in theory justify frb. However it is a contingent theory, not a first principles theory. By that I mean it would be justifiable only if it were the case that government ipso facto (inevitably) steals from banks and from demand deposit customers, which of course means we’re talking about one party doing evil to defend itself against another party that initiates evil. But this does not justify frb from first principles, any more than my killing someone else to prevent them from killing me first does not justify murder from first principles. It only justifies killing on a contingent basis. If it could be proved that governments ipso facto steal from 100% reserve banks, then frb could be justified.
Upon analyzing your theory, I must say that as with all human action, the act of stealing always depends on choice. It is not inevitable. It is not inevitable that governments will steal from 100% reserve banks. The Bank of Amsterdam was almost 100% reserve during the 17th century for around 100 years and government did not steal from it during that time. So that one case empirically rules out the theory of inevitability. Since the theory is ruled out empirically, it cannot be accepted as valid. Your theory, just like all other attempts to justify frb, fails.
What is inevitable with government is that they will ipso facto steal from people, because government cannot exist unless it violently declares monopoly authority in protection and security services over a given geographical territory, which of course means they must steal from all those in that geographical territory should those individuals disagree and do not consent to hiring that monopoly for their protection and security, and since there will always be those who disagree and do not want to be customers of that monopoly, there will always be theft as long as government exists.
Since banks are a source of money, one could argue that there is a high likelihood of governments stealing from 100% reserve banks, and I would accept the possibility that in the past, some banks in some places could have wanted to engage in 100% reserve, and tried, but were perpetually victimized by government confiscation and so reacted by engaging in frb, to minimize the amount of money the government could steal relative to the amount of “money” its customers could own. In those cases, I would say that even though frb was still fraudulent, it was nevertheless a well intentioned practice. In that case, I would say frb is much like a government policy. Well intentioned, but deep down it is evil and causes economic destruction. The correct reaction to government stealing from banks would be for the population to attack that bank theft and try to stop it, and establish mechanisms to prevent government from stealing from the banks, like establishing secret bank accounts, or people holding secret gold storage facilities, or perhaps well-protected biometric protected accounts that require the bank holder to be physically present for withdrawal of the money.
Whatever the solution, it is always true that the solution to one evil is not to engage in more evil. The solution is to attack and stop the original evil. Quasi-monetarists like you remind me of reluctant psychologists and scientists in Nazi Germany. In person and often secretly you say you are against certain policy practices, but in public, and in many cases because it your income and livelihood depend on it, you become apologists and rationalizers for evil, and in some cases advocates of evil.
You rationalize in the same way that another pro-inflation yahoo who called Ron Paul a “pinhead” rationalized the Fed. Not saying you support the Fed, just saying you rationalize like he does. He said that those who attack the Fed are idiots because the Fed “only” taxes the people 2% per year (through the inflation tax), whereas Congress taxes people over 40% per year. Inflation in his view is small potatoes and thus not a source for concern. He is rationalizing evil by saying its not as big as another evil. You rationalize frb evil by saying that government theft of 100% banks is a bigger evil.
Correction:
“Banks and frb apologetic customers are not the only relevant parties to frb. It is banks and frb apologetic clients who intervene to prohibit fraudulent behavior”
should read
“Banks and frb apologetic customers are not the only relevant parties to frb. It is banks and frb apologetic clients who intervene to prohibit non-fraudulent behavior”
I thought the point that Alchian is trying to make is that a reserve for a crisis should be able to be drawn down during the crisis. The key phrase in his water tank analogy is “at all times”. If this is without exception, than even times of bank runs would still constitute “at all times”. And so, if there’s a run on a solvent bank, even if they have enough cash on hand to meet the demand, they would instantly need to liquidate their longer-term positions, calling in loans, in order to maintain their reserve requirement “at all times”. This could create secondary spill-over effects. But the flipside is that, if the bank is unable to liquidate some of its balance sheet, it will NOT be able to provide the cash to their depositors AND maintain their reserve requirement.
And so, I think the point is that a rigid reserve requirement law, if held to the letter, cannot actually protect anyone but the running depositors.
That’s the point that Russ was making too. The crisis in Japan hit and the oil reserves couldn’t be accessed precisely because of the reserve requirement, eliminating the entire point of the reserves until the pols changed their stupid law.
The lesson, in the end, is that politics has no business setting any of these things.
Question:
Isn’t the issue really the mismatching of maturities, not “fractional reserves”? If a bank makes a 10 year loan using money which is meant to be available on demand, therein lies the challenge. But that same problem exists for ALL maturity lengths. If a customer puts their money in a 5 year CD, that money couldn’t be used for any investment with longer than a 5 year maturity. Isn’t that right? If I am correct in my understanding, I would expect that such a rule would dramatically reduce the supply of loanable funds and make capital markets significantly less liquid. That may be a good thing. But I think we already have “banks” with 100% access to all of your deposited cash: a safe.
Yes mismatches of maturity have been considered by some 100% reservers (e.g. de soto) as FRB.
They’d have to otherwise in their 100% reserve world time deposits would become currency. I am not sure now but something like this was one of the main criticism’s on why the peel’s act failed.
The market seems to naturally like fractional reserves because they allow people to make loans with money they’re not currently using to buy stuff with – at a very low cost. i.e. you get interest from your warehouse instead of paying them a fee. To me it seems as though to a non-legalist 100% reserver, FRB is a disaster waiting to happen and then when it does it becomes a sort of taboo and no one will dare try the system again. But thats really implausible, and moreover just a wild, highly improbable, extremely naive prediction about the market.
All that being said I think the legalist 100% reservers have a better argument on economic and pragmatic grounds than the non-legalists, however they have a worse argument on libertarian grounds.
P.S I made up the term legalist 100% reserver to denote those who would have 100% reserves mandated by law.
I don’t think that this dispute about FRB in the free market is even about economics.
Assume a warehouse receipt for gold or silver and a 100% reserve guaranty and let’s call that “A”. You could probably purchase dinner at Chili’s with an A and get fair value in change. The depositor, the bank and Chili’s all know exactly what A actually is.
Assume a $30,000 mortgage note and let’s call that “C”. While C may have value and you may be able to sell it, you probably couldn’t use it to buy dinner at Chili’s and get fair value as change. Of course, the debtor is not holding $30,000 of gold or silver at the present time for benefit of the creditor but it is still a legitimate contract.
Let’s call the fractional reserve banking note of a free market bank “B”. Is B more like A or more like C? It certainly isn’t the same as A. It wouldn’t be fraud if the depositor, the bank and Chili’s all know exactly what it is, but to the extent a B is passed off as an A to either the depositor or Chili’s, I submit there has been fraud. I’m not going to lose any more sleep worrying about whether issuing B ‘s is a practical way to do business in our future Rothbardian utopia. It may or may not be, but a B isn’t an A.
Your reasoning is correct IMO.
A loan contract backed by the credit worthiness of the borrower is not the same thing as a demand deposit contract backed by the actual property being deposited. A might appear to be B, but A is not B.
Even if the demand depositor knew the deposit will get loaned out, even if Chili’s knows what they are receiving, *somebody* is getting defrauded, which is made explicit when the effects of frb (business cycle and thus recession) are manifest.
As an outsider to banking, I am trying to catch up a bit here.
Wouldn’t it seem an appropriate business practice on the part of a bank whose reserve requirement is mandated by the government or financial authority at X% of all deposits, to represent contractually to all depositors that upon any initial request, fully X% of said deposits will be immediately refundable, with the balance remitted on a schedule compatible with the liquidity of currently loaned funds?
Is this actually the case?
It seems as though to avert a banking crisis one only needs limit any client’s immediate-withdrawal expectation (in % of their total deposits) to parity with the reserve requirement mandated by financial rules (or in any case, to the reserve level utilized by the bank.)
Then, Dr. Murphy’s point holds, in that even in a crisis, the total immediate withdrawals by clients cannot by contract exceed the reserve held by the bank. In a crisis, as the bank was handing out withdrawals, they could write each off the reserve requirement held against them, and though the “tank” of funds would be emptying, the level of the “tank” required by law or regulation would be descending at the same pace.
I know it is simplified, but couldn’t something of the type work?
Actually, the problem with this post is Mr. Murphy, and others, fail to realize fractional reserve banking is dead. It no longer exists. The banking system is never constrained by reserves. Never. Does not matter if the reserve requirment is 0%, or 100%, only the composition of a banks balance sheet changes, not the size. Please find me a loan officer that cares about a banks reserve positon before making a loan?
Canada has a 0% reserve requirement. Is there banking system doomed?
You guys do recognize the differance between capital and reserves, right?
You’re right, but only if the Fed keeps inflating and accommodating the banks as they expand credit. Operationally, banks don’t use the reserve ratio requirement. Functionally however, the reserve requirement is what ultimately determines the amount of credit expansion banks can engage in.
It’s kind of like a car. Operationally, the distance you can go is determined by your speed times the time you travel. As long as someone keeps accommodating you and keeps filling up your gas tank, then your operationally determined distance is your speed times the time traveled. However, if that person should stop filling your tank, then functionally, your distance is now a function of the size of your gas tank (and your mileage, which we will ignore for simplicity).
Transferring the analogy to the real world of banking, the person filling up the gas tank all the time is the Fed, the gasoline is newly created bank reserves, the distance traveled is credit expansion.
As long as the Fed keeps filling up the gas tanks of the banks, then operationally, the distance the banks can go is a function of speed and time. However, if the Fed stops filling up the gas tanks, then the distance the banks can go is determine by the size of the gas tank. The bigger the gas tank (the lower the reserve requirement) the more credit the banks can issue. The smaller the gas tank (the higher the reserve requirement) the less credit the banks can issue.
If the Fed should stop inflating, and every other rule remains in place, then eventually the reserve ratio WILL be the limiting factor in further credit expansion and WILL determine the maximum amount of credit banks could issue according to that traditional money multiplier pedagogical tool typically used by Austrians.
In Canada, where the reserve requirement is 0%, this requirement is operationally overruled by Canada’s (relatively high) capital asset requirement. Because of this, the traditional money multiplier pedagogical tool cannot be used to determine the upper limit to how much additional credit Canadian banks can issue.
We again require a refresher course on the intellectual history of MMT.
The initial problem with MMT, as Mises noted 100 years ago, is that it is acatallactic. In other words, it completely ignores the study of individual human exchange [what else is new?]:
Another acatallactic doctrine seeks to explain the value of money by the command of the state. According to this theory the value of money rests on the authority of the highest civil power, not on the estimation of commerce. The law commands, the subject obeys. This doctrine can in no way be fitted into a theory of exchange; for apparently it would have a meaning only if the state fixed the actual level of the money prices of all economic goods and services as by means of general price regulation.
http://tinyurl.com/4tn67j4
MMT godfather Abba Lerner was busy as late as 1980 constructing a Rube Goldberg type straightjacket of price controls demonstrating that MMT’s advocates were quite aware that it has a serious problem with price inflation:
Initially he toyed with various administrative wage and price control policies, but he found those lacking and soon gave them up. He replaced them, first, with a tax based incomes policy and ultimately, a market based[!!!] incomes policy in which property rights in prices are set and individuals have to buy the right to change prices from others who change their price in the opposite direction. It was this idea that formed the basis of our market [!!!!!!] anti inflation (MAP) book. (Lerner and Colander 1980) Under MAP, rights in value added prices would be tradable so that any firm wanting to change its nominal price would have to make a trade with another firm that wanted to change its nominal price in the opposite direction. Thus, by law, the average price level would be constant but relative prices would be free to change [page 12]
http://tinyurl.com/4rfk3jk
The Table of Contents to Lerner’s book “The Economics of Control” [which says it all] expresses his purpose as an attempt to save socialism:
Chapter l. INTRODUCTION. THE CONTROLLED ECONOMY
The fundamental aim of socialism is not the abolition of private property but the extension of democracy. This is obscured by dogmas of the right and of the left. The benefits of both the capitalist economy and the collectivist economy can be reaped in the controlled economy. The three principal problems to be faced in a controlled economy are employment, monopoly, and the distribution of income. Control must be distinguished from regulation. Liberalism and socialism can be reconciled in welfare economics.
MMT is a ghastly horrible system based upon surreptitious theft of purchasing power by a neo-totalitarian controlling socialist state. Beware.
I think John Papola’s statement that this issue is really one of maturity risk than the Rothbardian “FRB is fraud” dogma is correct. The fundamental issue involved here is how well one person or group (a bank) can manage its future repayment obligations (demand deposits, cds, etc.) to its creditors i.e. depositors. Banks that can manage those obligations well provide the right balance of liquidity demanded by savers and investors as cleared by interest rates. Mismanaging those obligation causes waste in the form of losses but mismanagement is not fraud.
Depositing money into a bank, even in a demand deposit account, inherently entails risk on both sides of the transaction. Demanding that one party (a bank) take on some fixed amount of risk or to make the other party (depositor) immune from that risk (via 100% reserves) is just the same as rigging prices in favor of a buyer or seller.
I think that what is getting lost in the FRB discussion is the fact that the value of a banks long and short term assets necessarily fluctuate with the market, which is a contributing factor against its solubility so it is impossible for a “neutral” third party to arbitrarily “impose” a level of risk that is “appropriate” between a depositor, who is concerned that the bank will be able meet its future obligation to pay back his deposit, and a banker, who is concerned that his loans and other investments will be able to generate the revenue needed to meet and exceed (profit) those obligations. Both parties must come to a mutually beneficial agreement they both can live with, that is the essential function of interest rates.
Risk is something that is inherent in life, using sound money in a banking system allows us the ability to exchange that risk for a certain price and it is not something that can be “preset” to any “appropriate” level.
“I think that what is getting lost in the FRB discussion is the fact that the value of a banks long and short term assets necessarily fluctuate with the market”
No. What is getting lost is the differeance between reserves and capital. Reserves requirements can always be met in a fully functional inner bank market. Always.
Everything you learned in Econ 101 about reserve banking and the money multiplier no longer applies. It’s all a myth.
http://bilbo.economicoutlook.net/blog/?p=10733
AP Lerner,
What I meant was a bit more fundamental than Econ 101. I was speaking more of the idea that a bank does not need any set “reserves” at all, FRB or no FRB. The value of its assets serves as its ability to meet its liabilities, long or short term. FRB reserve requirements are just a fancy way of forcing a bank to arbitrarily accept a set level risk in managing those obligations. The loan is an asset of the bank along with the collateral that backs it. The collateral is comprised of both the risk of future production ability associated with a person’s credit plus the market value of the collateral. i.e. an office building or strip mall or home has a value that is set by the market, therefore the value of the bank’s loan assets are also set by the market so its value at any time will necessarily have an impact on the banks “reserves”, in this sense its ability to match its long and short term obligations with its long and short term assets. As the value of the collateral on its loans increases its future ability to do this is also improved.
The idea that FRB “creates money from nothing” is fallacious. When a bank makes a loan, values are being exchanged. “Credit is not something that a banker gives to a man, it is something that the man already has” – H. Hazlitt. All that is being exchanged is the time value of future production. The person who takes the loan “creates” the new value from productive activity, which is used to repay the loan. The bank is getting a return on the “risk” it created not the money.
“I was speaking more of the idea that a bank does not need any set “reserves” at all”
Agreed!
“FRB reserve requirements are just a fancy way of forcing a bank to arbitrarily accept a set level risk in managing those obligations”
Disagree. Capital requirements regulate risk. Reserves regulate liquidity. Big difference.
“The idea that FRB “creates money from nothing” is fallacious”
Mr. Murphy vehemently disagrees. But then again, Mr. Murphy does not understand the banking system.
“Of course, weirdness is not proof of dubiousness, let alone fraud, but bankers who engage in fractional-reserve banking really do “create money out of thin air””
http://mises.org/daily/4499
AP Lerner,
Liquidity is an attribute of risk. If an asset is said to be illiquid then it entails a certain type of risk. Even a very liquid asset has risk as you cannot “eat” your gold, dollars, or t-bills.
Risk is the uncertainty of the future. Funamentally, banking is the business of managing the future expectations of savers and consumers, that is why every society that uses money necessarily has bankers.
I’m not sure what any of this has to do with reserve requirements. But I will say that ‘banking is the business of managing the future expectations of savers and consumers’ is not true at all. Banking is all about transmitting credit. Bankers are not required for me to acculate savings. And bankers are not required for me to consume. But bankers (or at least some variation of banking) are required to transmit credit.
Sounds like you are stuck in gold standard mentality, much like the author of this blog.
Well, if someone adheres to the concept of commodity money, then FRB must be fraud. You either lend your money to the bank, then you give up control over the money. In return you will receive the principal plus interest in the future. If you make a demand deposit, you do not give up control. By the very nature of this transaction the bank is obliged to keep 100 percent of this money in its vault because it has not gained control over it. The advantage of the concept of commodity money is that you may change the word “money” for e.g. “grain” and the concept still works (well, most of it).
I do not understand MMT at all. Money seems to be reduced to a bookkeeping entry. And if reserve requirements can be met in any case, money does not seem to be scarce. But how can it be an asset then? How does it relate to wealth? Does anyone really believe that wealth can be created by creating money? It seems that changes in the money supply influence human behaviour. But why should this be favourable?
Impairment,
FRB is not fraud. Putting money into a bank is the same as lending it, demand deposit or not. The bank is not “obliged” to do anything other than what it agreed to do in exchange for your loan, with or without interest. Physically giving money into another’s care is fundamentally an act of giving up control. Control is indivisible, a demand deposit is just a banks way of agreeing to meet a certain level of obligations (the value in your checking account) that you have made on its behalf. A contract that can be revoked at any time for any reason. It does not mean that the bank is guaranteed to meet those obligations outside of any rational context.
Well, I disagree. Putting money into a bank is not necessarily lending. A demand deposit means that the depositor may withdraw the money any time he wishes to do so. In order to fulfill this contract the bank needs to have the same amount of money available at any time. The bank may mix it with its money or the money from other customers but has to keep it available. Therefore, the depositor has not given up control.
The point is: what did the parties really agree on? From my point of view the corresponding contracts are self-contradictory, because they want to give control over the money to the bank AND to the depositor.
“…but has to keep it [money] available”
Wrong. The bank only has to keep “some” of it available. Only enough to meet its short term obligations. There is no “pre-set” amount that is proper as that can only be determined by the market i.e. by an interest rate that “clears” savings and consumption.
Control of the money is transferred to the bank; they are physically holding the money. That is control. An item cannot exist in two places at once nor can it be moved in two different directions at once. What you get in return for your deposit is only a promise that the bank will be able to repay you back upon some future demand. That is what I mean by “control”.
You have voluntarily taken on the risk of repayment by loaning your money to the bank. There are no grounds to forcibly demand that the bank provide some minimum amount of guarantee that it will do so, not unless it were agreed to in advance by both parties.
In making its loans using those funds it can only physically transfer out as much as it can or has taken in. That is the only “limit” that can apply in a metaphysical sense. Everything else is an expectation of future actions on the part of others, it is a matter of managing the future risk of matching short and long term obligations. A balancing act that requires skill and knowledge and provides an essential service to the market.
Wrong. You are presuming the premise as your conclusion in order prove the conclusion. You can’t do that.
A demand deposit is not a loan.
A demand deposit is a deposit of money whereby the money should be kept on hand at the bank at all times, ready for the client’s withdrawal at any time. Loans are money the property title of which gets transferred from client to bank, after which the bank should then be able to loan it out.
FRB is fraud because it results in more than one ownership title granted to the same property.
One who deposits money in a demand (checking) account is NOT making a loan. The money remains in the name of the depositor.
You are confusing the physical transfer of money to the bank with ownership title transfer. They are not the same thing.