28 Jul 2018

## A Thought Experiment on Fractional Reserve Banking

Enrico in the comments of my FRB lecture writes:

“if someone lends 100\$ to a bank for a fixed time period, and then the bank makes a loan of 90\$, no boom&bust cycle will happen. The reason is that the 90\$ loan granted by the bank is “backed” by (at least) 90\$ real savings from the initial lender. But the same conclusion is true in fractional reserve banking. If someone deposits 100\$ into a bank, he is saving (= not consuming) that money until the moment when he’ll withdraw it. Thus, if bank reserves are sufficient for satisfying depositors’ withdrawing, it means that bank loans are backed by real savings. If banks reserves happen to be insufficient, the bank goes bankrupt and the depositors will have to wait for getting their money back (= not consuming in the meantime); therefore, they will be “forced” to save such amount of money. In conclusion, in a free banking system, bank credit is always backed by real savings, and thus cannot generate boom&bust cycles.”

Before we ponder this, let’s think about a different scenario.

Suppose there is a rich man in a small community. He has (say) 1,000 ounces of gold stored in his personal vault at his house. Depending on the vagaries of his income and expenses, the man dips into his personal stockpile, but typically he can go for months at a time without the stockpile ever falling below (say) 500 ounces.

Some workmen come to the rich man’s house to add another bedroom. One of them realizes that he can surreptitiously carve out a small opening into the vault from the outside, which is invisible to a casual passerby.

From that point on, this workman makes regular trips to the vault. He sneaks out anywhere from 100 to 200 ounces of gold at a time, taking them from the back end so that the rich man wouldn’t notice it when he enters his vault from the inside. The workman isn’t a fool; he doesn’t blow the money on consumption, but instead makes loans in the community that he thinks will pay off. When someone pays back a loan, the workman puts the principal back in the vault (at night of course), and keeps the interest for himself. Obviously, if someone defaults on a loan, then the workman has to eat the loss out of his gross earnings on the other loans.

My question: ECONOMICALLY (I’m not talking about ethics, morality, or legality), is there any problem with this? Will some investment projects be funded that otherwise would not? If so, is that a problem?

#### 62 Responses to “A Thought Experiment on Fractional Reserve Banking”

1. Transformer says:

If the rich man at first just hoarded the gold then decided to start lending some of it out then I think initially this may cause interest rates to fall (and potential cause some bad investments to take place) then the market (via the price level) would adjust and interest rates would be back to where they were before

I cannot think of any functional difference between this and the case in the thought experiment so my answer would be that this could initially cause some investment projects to be funded that otherwise would not be but that this would be a short-term effect.

2. Michael says:

Bob I posted a similar comment as Enrico to you back in the debate thread , and I recall you mentioning that you would address in an upcoming article but I haven’t seen it yet.

Economically, couldn’t we just say that the Rich man no longer ‘owns’ the gold the workman is loaning right now, because the workman has stolen it and is exercising control over it. The only difference is that the Rich man is unaware that the theft has occured.

And so again, similar to my previous comment, is the issue that you see here purely that the Rich man is unaware, and so does not factor the true conditions (workman loaning) into his own decision making when he spends or loans the remaining funds?

And if so, why (from a technical perspective) would this still be an issue for FRB if all consumers were completely aware of the nature of FRB deposits?

I understand that people today are not aware, but I want to know why it would still be an issue if they were. Otherwise, the pernicious effects of FRB could be addressed through education and awareness?

3. Warren says:

This would make a great TV series. We would all tune in to watch this rogue loaner expand credit in his community while always at risk of being exposed by the authorities; who are focusing on how this tradesman managed to enter the banking business. I’d watch this but it’s too bad the title ‘Person of Interest’ has already been taken.

Is it bad economically? Only if he’s crap at vetting borrowers and their projects.

So if it leads to malinvestment, yes. But if this little town suddenly becomes a hub of positive hubbub businessing then no.

4. Dan says:

I don’t think this would result in a business cycle because you haven’t expanded the money supply and introduced it through the loan market. Unless I’m missing something.

• Bob Murphy says:

Dan, suppose the workman takes the real gold coins, but replaces them with counterfeit coins that look like the real thing. So when the rich man goes into his vault, even if he walked around and quickly looked at his stash, he would still think he had the full number of coins.

• Warren says:

That brings up another wrinkle.

What if he, unknowingly, uses these counterfeits for spending and they pass unnoticed but yet create positive results in the local economy?

• Bob Murphy says:

Warren asked: “What if he, unknowingly, uses these counterfeits for spending and they pass unnoticed but yet create positive results in the local economy? Is that bad?”

Likewise, what if the government runs a trillion dollar budget deficit building schools, bombs, and bridges that creates positive results in the national economy. Is that bad?

• Warren says:

That’s an interesting take on economic policy. I wonder if it should have a name? I’ll try to think of one, but I’ll need a moment.

• LB says:

• Dan says:

I don’t have a lot of time to think through this deeply at the moment, so I may be missing something, but I think it would depend on whether those fake coins are circulating in the economy. So if thief is going back in and still replacing the fake for the real coins when the loans mature then I don’t see how that would expand the money supply. OTOH, if the thief isn’t going back and replacing them, keeping the principle plus the interest for himself, while the rich guy has 800 real coins and 200 fake ones that spend the same, then that would certainly be expanding the money supply with the new money entering the economy through the loan market, and would cause the business cycle.

• Bob Murphy says:

OK Dan suppose the workman creates counterfeit gold coins and lends those out to people. (He doesn’t do anything with the rich guy’s stockpile.) When the loans get paid back, he goes around town and finds any of his counterfeits (he has special trackers on them that no one else detects) and makes one-for-one swaps with the genuine gold coins in his possession.

E.g. in January 2018 he creates 100 counterfeit coins and lends them out, at 5% interest. In January 2019 he gets paid back 105 coins, where 104 of them are genuine. Then he hunts down the other 99 fake coins and swaps real ones for them (the holders of the fakes are indifferent), and then he destroys the 100 fake coins. He keeps the 5 real gold coins he earned as interest on the loan.

If he wants, of course, he can recreate the 100 fake coins and do it all again.

So, in this scenario, do you agree he is setting in motion an Austrian boom-bust cycle?

Finally, if you’re with me so far, why is there a qualitative economic difference if he first swaps the 100 counterfeit coins with real ones from the rich guy’s stockpile, rather than directly lending them out into the community?

• Dan says:

Yes, I think that would cause the business cycle. I think the difference from the scenario with the rich guys stockpile is the rich guy isn’t spending those coins. Like if the rich guy was out there spending all 1000 the of his real and counterfeit coins at the same time as the loans are out there then the money supply was increased and the loans aren’t backed by real savings any longer.

• Bob Murphy says:

Dan wrote: “Yes, I think that would cause the business cycle. I think the difference from the scenario with the rich guys stockpile is the rich guy isn’t spending those coins.”

OK Dan, let’s walk through this. (BTW I’m not patronizing you; I am myself walking through this to see how it works out.)

Scenario #1: The thief creates 100 fake coins. He sneaks into the rich man’s vault at night, and swaps them out for real coins. Then he lends the real coins out into the community, pushing down interest rates. The people pay back the loans, the thief pockets the interest, and swaps out the 100 coins in the rich guy’s stash at night. The thief destroys the 100 fake coins.

Scenario #2: The thief creates 100 fake coins. He lends them out into the community, where nobody realizes they are fake. This pushes down interest rates. After he gets paid back, he pockets the interest, and retrieves and destroys the 100 fake coins.

You are saying Scenario #1 does NOT cause malinvestments, but Scenario #2 does. Right? So in your framework, if the rich guy is holding 100 fake coins unbeknownst to him, that doesn’t screw anything up, but if any other merchant in the community has fake coins in his cash balances, that does screw up the economy.

(Obviously I’m trying to provoke you, but I’m not claiming I’m right. Maybe there is yet another important difference you want to point out.)

• Dan says:

I just default to that you’re not patronizing me, and I’m not sensitive anyways, so you don’t have to worry about qualifiers with me.

And, yes, I think scenario 1 doesn’t cause malinvestments. The reason being, he is loaning out geniuine savings. The fake coins are irrelevant because they aren’t circulating in the economy. It’d be like he just used an illusion to trick the rich guy into thinking no real coins are missing. However, if the rich guy goes out and buys a boat for 1000 coins while this loan is still out there, you now have an increase in the money supply with that new money having been introduced into the economy through the loan market.

The only area I’m disagreeing with you is with whether the loans are backed by genuine savings or if the are backed by an increase in the money supply. Obviously, I agree the thief is distorting the preferences of the legal owners of savings of he loans it out without their consent or knowledge, but it’s still real savings.

And I’m not saying I’m right, I’m just saying as far as I was aware the business cycle required both an increase in the money supply, and for that new money to enter through the loan market. I didn’t think that would apply to someone stealing genuine savings and loaning it out since no new money was created.

• Bob Murphy says:

Dan wrote: “And, yes, I think scenario 1 doesn’t cause malinvestments. The reason being, he is loaning out geniuine savings. The fake coins are irrelevant because they aren’t circulating in the economy.”

OK but I think you’re not seeing the “trick” I’m building into these scenarios.

In Scenario #1, what’s the total money supply? It’s however many gold coins, plus 100 fake ones.

In Scenario #2, what’s the total money supply? It’s however many gold coins, plus 100 fake ones.

Why do you think the money supply has gone up in Scenario #2, but not in Scenario #1? This is why I said you must think if the rich guy is holding less real money than he believes, it’s no problem, but if other merchants do the same, it *is* a problem.

(Another curve ball: Suppose we’re in Scenario #2, where the thief directly lends out the counterfeit coins. But his sole customer is…the rich guy! Who maybe ends up spending 100 of the coins, so that the community has 100 more “in circulation” while he has 100 fake ones in his vault. So it looks like I can transform Scenario #2 into #1 if the rich guy happens to be the initial borrower.)

• Dan says:

I mean scenario 1 sounds no different to me than if a thief breaks into a safety deposit box, steals all the money, puts it into a CD. I’m not seeing how that would cause the business cycle or why him returning the principle before the owner realizes he was robbed would make any meaningful difference. The money supply hasn’t been changed either way.

• Bob Murphy says:

Dan wrote: “I mean scenario 1 sounds no different to me than if a thief breaks into a safety deposit box, steals all the money, puts it into a CD. I’m not seeing how that would cause the business cycle or why him returning the principle before the owner realizes he was robbed would make any meaningful difference. The money supply hasn’t been changed either way.”

OK, but then you should also understand why Enrico doesn’t think fractional reserve banking causes the boom-bust cycle. Isn’t that pretty much like your CD scenario?

• Dan says:

I don’t think they’re equivalent at all. FRB are certainly increasing the money supply. If someone steals my money and puts it in a CD or I decide to put my money into a CD on my own, it has no impact on the money supply.

I guess my two questions would be, do you agree that increasing the money supply is necessary component as far as causing the business cycle? I might have a misunderstanding there.

And if increasing the money supply is a necessary component, how does the theft scenario increase the money supply? Maybe I missing some subtlety in how taking the money from the guy without him realizing it increased the money supply.

• Dan says:

I didn’t see your second to last comment. I’ll have to ponder it later tonight because I might be missing the trick. As of right now I’m not seeing how your initial scenario increased the money supply, but I admit the fake coins make it murkier to see when you add that in.

• Enrico says:

Scenarios #1 and #2 are equivalent. As long as the rich guy is not spending the money in his vault, the loans granted by the thief are backed by real savings. Lending gold coins or fake coins changes nothing in terms of the resulting interest rates; thus, we should agree that if scenario #1 doesn’t generate a boom-bust cycle, #2 doesn’t as well.

5. Silas Barta says:

The way you’ve constructed the example, the worker has committed unlimited real resources to replace the value of anything lost by the loan, since he always uses personal resources to cover any failure to pay any loan. This is equivalent to a fractional reserve bank whose owners commit to working off any shortcoming by depositors without expanding the money supply.

• Dan says:

I don’t think it would even be like that. It wouldn’t be fractional reserve considering the depositors wouldn’t have access to the money loaned out because it’s physically not there. It’s no different than a 100% reserve bank loaning out timed deposits, but keeping all the interest for themselves, paying the depositor nothing for the loan. The difference being this is done by stealing from someone who has no idea his money is missing, and who will never spend enough to find out he’s being robbed before the money is replaced. The added wrinkle he put in in response to my comment could be like fractional reserve banking if the fake coins are being used to expand the money supply though.

6. Bob Murphy says:

OK I think just about all of you (so far) have said that the workman might be a thief, but he won’t set in motion a boom-bust cycle. This intrigues me.

I guess you are saying that as long as he makes responsible loans, pushing down the interest rate (since his actions allow more total loans to go out into the community), that those investments are not malinvestments.

So suppose the workman never realized he could break a hole in the wall, and that money stayed in the rich man’s pile. Interest rates would be higher (relative to the counterfactual of the workman breaking in at night), and some of those investments wouldn’t occur.

So are you saying in the original, no-theft scenario, interest rates are artificially high and preventing justified investments from occurring? Isn’t it weird that you are forced to conclude that, even though I haven’t told you any other information about the scenario? For all we know, the rich guy saved up those gold coins a decade ago, and prices/wages/interest rates all adjusted to his actions. Yet the economy was underperforming, just waiting for an innovative thief to free some of that dead money into the loan market where it could fund justified investments?

• Dan says:

I’m not saying they’re artificially high. I’m saying that lowering the interest rate by loaning out real savings, whether done by the thief or the rich guy deciding to do it on his own, won’t set in motion the business cycle unless the money supply is being expanded to lower it.

• Dan says:

For example, I don’t think it a mugger takes my money and loans it out that that would cause a business cycle. Regardless of whether he grows a conscience and decides to give my money back after he makes some interest. It certainly distorts the preferences of the legal owners of the savings, but I don’t think it sets in motion a business cycle.

• Enrico says:

@Bob
An action can lower interest rates (or any other kind of price) but that’s not necessarily leading to a b&b cycle. For example, in another scenario, the rich guy could suddenly decide to lend out his savings, thus lowering the interest rates to a new level (which is given by a higher supply of available credit).

Regarding your question, I don’t see any problem in saying that the economy may be underperforming with respect to the maximum amount of possible investments. Perfection is not a thing of this world. Plus, the market price system can adjust the quantity of investments to the amount of real savings.

I don’t want to abuse your time, but I think it would help to consider also my second example (the one regarding “1-day automatically renewable loans to bank”) in the previous post of yours. Anyway, thanks for writing about this stuff!

• skylien says:

That example, imo, is exactly like the example I gave where those kind of savings of lot’s of people are pooled together, so that they could be used to make more loans, without those owners having to forfeit the security of having a rainy day fund.

As long as the proportion of the pooled rainy day savings that is loaned out is below the actual need of rainy day demands of some people it would work out.

It is also clear that if the rich man made this very same loans the thief makes himself, there couldn’t be any problem, right?

It only is a problem the very moment he needs the money for a certain emergency demand (or even planned demand, for which he needed to save up a lot, like a house) which was the initial reason he build up that amount of savings the first place. No matter if the thief makes the loans, or the rich man himself, if this rainy day is here, he can’t make use of it.

So the difference can only be that if he does it himself, that he knows it, and if the thief does it he doesn’t know it.

So if FRB is done clearly openly so that every person knows what is going on, it should not be a problem.

• skylien says:

“just waiting for an innovative thief to free some of that dead money into the loan market where it could fund justified investments?”

Rainy day funds really feel like it is dead money (just like fire insurance payments feel like you pay something for nothing), but we know it isn’t. Yet if we pool together we can make use of some or maybe even most of it for productive purposes.

7. Tel says:

My question: ECONOMICALLY (I’m not talking about ethics, morality, or legality), is there any problem with this? Will some investment projects be funded that otherwise would not? If so, is that a problem?

There cannot be a problem economically, because economics is descriptive and not normative.

The workman has an individual incentive to take advantage of his back door into the the vault, while the owner of the vault has an incentive to minimize risk and therefore close off any back doors he knows about. Neither of these is a “problem” in any universal economic sense, it’s merely two individuals with incompatible incentives.

8. Transformer says:

I think Enrico is largely right.

I think though that it is interesting to consider what would happen if banks transition from non-FRB to FRB. The money supply would expand in much the same way as when the thief steals and lends the rich man’s money. Interest rates may fall as the transition from non-FRB to FRB takes place until the price level catches up and we hit a new equilibrium. In the transition period mal-investment may be possible.

I think ABCT is based upon the thought that under some circumstances FRB-banks may for some extended period of time expand the money supply by increasingly reducing the reserve-ratio used by FRB banks. By doing this they both potentially both distort people’s view of the real rate of interest and increase the risk of bank failure.

Is this a non-standard view of ABCT ?

• Transformer says:

And the Central Bank just increasing the quantity of base money faster than people were expecting would be a variation on this theme – probably more common in today’s world.

• Dan says:

Standard ABCT from Mises would be increasing the money supply and introducing that new money into the economy through the loan market causes the business cycle. This would include all fractional reserve systems and all central bank systems.

• Michael says:

Dan that explanation is too simple or high-level for the purposes of the discussion here because it just describes a mechanical interaction. An Austrian has to be able to explain the effect that interaction has on the individuals who comprise the economy to be satisfactory.

I.e. why is that relevant? How does it distort individual actions in Bob’s example?

• Dan says:

It was an answer to his question. If you want a more fleshed our understanding of ABCT there are numerous Austrians economists that have done this. For example, you can read Human Action by Mises.

9. Keshav Srinivasan says:

Bob, to be clear the Austrian position doesn’t depend entirely on people having incorrect beliefs, right? Even if everyone had a complete understanding of fractional reserve banking and where every dollar was, you believe that FRB would still cause a boom-and-bust cycle, right?

• Michael says:

The Austrian position must rely on everyone’s beliefs. The price system is partially based on the interaction of all preferences and beliefs affect them. The strength of the Austrian analysis it’s that it is rooted in subjectivism re: prices.

ABCT is all about some circumstance introducing discoordination of those preferences, leading to a msallocation of resources. Beliefs about the current value/quantity of money vs the future value/quantity of money is at the very heart of the issue.

So if everyone is completely, wildly mistaken the business cycle will be more severe then if everyone is only very marginally incorrect.

But yes I would really like to hear Bob weigh in on whether he believes that two agents merely having access to the same pool of funds, even if they both understand the risks and constraints that accompany that, will still cause the business cycle.

10. Harold says:

There is a good chance that the loans will not be repaid and the coins never put back. Looking at expected payback, this must surely be less that the whole number of coins, since if the loans are good, only the number of coins are replaced, but if loans are bad fewer coins are replaced.

11. Charles DuBois says:

Bob,

Maybe I’m being stupid, but isn’t this discussion based upon a false premise? That is, banks, for example, do not intermediate deposits or reserves. When a bank makes a loan, it marks up its assets (the loan) ) and it marks up its liabilities (the deposit from the loan). These are accounting entries made out of thin air. They are made with no reference to deposits or reserves. If a bank did then find it needed more reserves (not an issue these days obviously), it would then obtain them, after the fact, from another bank or, if necessary, the Fed would supply them.

Thus, increases in loans increase the money supply and decreases in loans decrease the money supply.
If this leads to malinvestment, etc., it is consistent with Austrian business cycle theory. One of the principal reasons why mainstream economists missed the GFC is they thought that bank lending was just moving money from one pocket to another – and therefore was not important. In reality, banks were expaniding their balance sheets to what would be unsustainable levels when the underlying collateral began to weaken. This supports the boom-bust concept. Thanks..

• Enrico says:

@Charles
In a free banking system, if a bank receives 100\$ in deposits and tries to loan (for example) 150\$, it goes bankrupt within the same day. In fact, the 150\$ “bank money” spent by bank’s debtors are deposited in other banks, and they immediately claim an equivalent amount of “real money” from the first bank.
Of course, another bank could lend the missing 50\$ to the first bank. But then, the 150\$ loans granted by the first bank are backed by real savings: 100\$ savings from the depositors of the first bank, plus 50\$ savings from the depositors of the second bank.
In conclusion: without a Central Bank, the banking system can lend only the depositors’ savings.

• Charles DuBois says:

Yes, the bank could not loan \$150 in your example as it would violate capital constraints – assuming say \$25 in capital.
I thnk you are correct that without a central bank, banks could not operate the way they do. But there is a central bank. All loans are created “out of thin air” – not from deposits or reserves. Loans create deposits.

And this is nothng new;

Robert B. Anderson, Treasury Secretary under Eisenhower, said it in 1959:

When a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposits; it was not previously paid in to the bank by anyone. It’s new money, created by the bank for the use of the borrower.

The Bank of England said it in the spring of 2014, writing in its quarterly bulletin:

The reality of how money is created today differs from the description found in some economics textbooks: Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

• Enrico says:

Allow me to make another example. Suppose that (in a gold standard system, without the Central Bank) I want to lend you 100 gold bars. They are very heavy to transport, thus we agree that it is more convenient to write a note: “everyone possessing this note can came and take 100 gold bars from Enrico’s caveau”. Now you can buy things by using this note, and the seller will came to me with the note in his hands for claiming tha gold bars.
Now: it is certainly true that I wrote that note “out of thin air”, but I didn’t create money. I just created a substitute for the already existing “real money” (the gold bars). Basically, I wrote a promissory note.

Banks do the same thing: in order to lend money, they don’t give you banknotes and coins; instead, they write on a computer that you can spend a certain amount of money. When you spend it through (for example) a bank transfer, another bank will claim “real money” from your bank. Therefore, your bank basically emitted a promissory note. And everybody can emit promissory notes “out of thin air”. The pint is that they must be backed by real money, or else the emitter will go bankrupt.

• Charles DuBois says:

Yes, thanks for the example. Let Bank A be the bank making the original loan. And let Bank B be the bank ultimately receiving the deposit (from Bank A) in your banking system example. At the end of the day, what has changed? Bank A has lost cash (real money), as you point out, which has been replaced by a loan on the asset side of their ledger. Their liabilities are unchanged. Bank B has added cash (real money) offset by an increase in their deposit liabilities.

For the banking system as a whole, the amount of cash (real money) is unchanged while both loans and deposits have increased. That was one point – that the loan created new deposits – deposits did not fund the loan. The other point is that the money supply, at least as defined, has increased – as deposits are part of the money supply.
But you are correct. No one is any wealthier. Assets and liabilities have both increased equally and the amount of real money is unchanged. In addition, I think you are also pointing out that the operation won’t work unless individual banks (such as Bank A) have sufficient capital and reserves to make a loan, lose cash (reserves) and still be meeting reserve and capital requirements. Agreed. That’s the limitation. But I think it is important to understand that when loans are increasing overall – so are deposits. Deposits are not funding the loans – unless, of course, I’m full of beans (always a possibility). Interesting. Thanks.

12. Dan says:

OK, I think I’m seeing my mistake. Unless I’m still off, it’s the fact that the he’s effectively removed the 500 coins he never touches from the money supply, and then the thief reintroduces those funds into the economy, increasing the money supply, through the loan market. Correct, or am I still not seeing it?

Also, this scenario makes it much less obvious to see than with a FRB, so it’d be interesting to see an article walking through an economy where this happens similar to your sushi article. If you have the time, that is.

• Bob Murphy says:

Hey Dan,

I think I will do one more blog post here, to try to motivate my thoughts. But yeah, the basic idea is that the rich guy still thought he had that money the whole time, yet the thief lent some of it out into the economy. So Enrico could be consistent in thinking it won’t cause boom-bust, but if one believes (as you and I do) that FRB causes it, then I think this case might too? It’s hard to see why it wouldn’t.

• Shailesh says:

Hi – Here’s my understanding. Look forward to any feedback and will see how it holds up during further discussions here.

Any increase in the money supply (whether by natural means as change in risk taking by individuals, credit creation with/without FRB, gold discovery or artificial means as money printing, etc; whether fraud or otherwise) should lead to a commensurate ‘boom’ in prices or activity/investments.

There is nothing inherently wrong or unsustainable with the boom. It will lead to a bust (i.e. these investments will become ‘malinvestments’) only if there is then a part of whole reversal in the money supply for whatever reason.

So, I believe we Austro-libertarians are wrong in thinking that bust necessary follows the boom (though it actually follows because the Fed, in its itch to control prices, decides to tighten money supply). The ABCT is useful but somewhat flawed and probably earns us a bad rep.

• Dan says:

Here’s one of the best articles ever written describing what makes the boom unsustainable. https://mises.org/library/importance-capital-theory

• Shailesh says:

Thanks Dan. Somehow, i think the article does a good job of rebutting Krugman without explaining why every ‘boom’ has to be unsustainable.

Yes, misallocations do require future adjustments and fraud, opaqueness, etc. increase the chance of misallocations but FRB is not a fraud

• Dan says:

Every boom isn’t unsustainable. I think a truly free market with 100% reserve banking would result in the biggest boom the world has ever seen, and I don’t think there would be a bust at all. We’re talking ABCT and why specific actions result in an unsustainable boom, not saying every boom is unsustainable.

• Dan says:

See this on why some booms are unsustainable. https://mises.org/library/how-business-cycle-happens

• Michael says:

If you mean that prices rise when the money supply increases, and you call that a ‘boom’ without any positive connotations, perhaps you’re right.

But when people talk about a ‘boom’ they mean it in the sense of economic growth in general, not just rising prices. Yes, if you just keep expanding the money supply the prices will continue to rise. But this doesn’t necessarily mean that the economy is experiencing economic growth from an austrian perspective because ‘more’ activity doesn’t necessarily mean ‘better’ activity or even ‘good’ activity.

So the semantics are important.

• Shailesh says:

yes, I don’t use the word ‘boom’ in a positive sense. Just something that raises the prices and shifts economic activity. I’m a austro-libertarian – not a fan of money printing – don’t think the fed’s money printing leads to a positive outcome even in the short run – some people benefit whereas some lose.

13. skylien says:

On another thought, what if this FRB thing vs 100% effectively is all a wash?

What bugs me in my analogy with grain is, that grain is real wealth. Money (only the monetary aspect of it) is only kind of a “mirror” of wealth. More money doesn’t mean we have more grain, steel etc…

Imagine of the total money supply on average 10% are always held in rainy day savings accounts, never used. Now compare this to a situation where all is used but the money supply is 10% smaller. Basically it is the same, same price level, same interest rates. The market respectively individual people do not take into account how much of the money supply is “actively” used or not.

So that would mean FRB cannot push the interest rate down in the long run, since the size of the money supply does and cannot have a long term effect on the interest rate. Only changes in the money supply have a “short” term effect on it, because after a while obviously prices are pushed up which will push the interest rate back up.

So from this point of view it is all a wash, and what needs to be kept small is changes in the money supply. So why would people go for FRB in a truly free market? Because it gives them an edge over others who don’t. And if others don’t follow it is their problem.

So maybe people would pool funds together via FRB because this way they can make use of their rainy day funds. In the long run this system should be stable, but it cannot cause more production than a 100% reserve system, because it changes the price level. What changes is that people pooling their funds via FRB engage in more risk, to earn more money and so influence the direction of investment in a different way than would happen with only 100% reserves.

So from this line of argument I would say: In a truly free market people would do FRB because they can, they can earn money using rainy day funds, it would be stable from the moment on money supply isn’t expanding anymore, and malinvestments from the expansion phase are dealt with. BUT there is no additional production happening compared to 100% reserves. So the thief robbing the rich mean only helps himself, but does not make the society any richer more wealthy.

• skylien says:

“So the thief robbing the rich mean only helps himself, but does not make the society any richer more wealthy.”

Should be:
So the thief robbing the rich man only helps himself, but does not make the society any richer or more wealthy.

14. LB says:

They will be forced to wait get a fraction of their money back.

The bank is bust, its lost all of its capital and more.

Hence you won’t get back 100% of what you are owed and you are locked in until the creditors pay, or the debt is sold

• Enrico says:

In the example, the bank eventually goes bankrupt only because it has no sufficient reserves to match depositors’ claims. But when bank’s debtors repay their loans, there’ll be enough money to repay all depositors. Depositors will get 100% of their money back.
Depositors would lose their money only if the debtors default. But such case would be a problem also in 100%-reserve-banking: if you lend your money to a bank for a fixed-time-period, and then the investment goes badly, you’ll lose your money.

15. guest says:

“My question: ECONOMICALLY (I’m not talking about ethics, morality, or legality), is there any problem with this? Will some investment projects be funded that otherwise would not? If so, is that a problem?”

I would say yes it would necessarily fund projects that otherwise would not get funded, and that it necessarily sets in motion the business cycle.

The reason is because each individual saves for reasons that are based on his own perception of his economic well-being. So, savings are going to contain information about individual preference rankings – not just for savings, but also for consumption.

This exact same scheme is the basis for all Ponzi schemes and central bank monetary inflation. The scheme only “works” when you are able to leverage other people’s ignorance about their real savings.

It’s not just the nominal money units with which “Free Bankers” should concern themselves. Even though the savers get their money back, there are projects that have been started, and prices that have been affected, that were not in accord with consumer demand.

16. Eric says:

Maybe I’m oversimplifying this, but isn’t the cause of the business cycle the discoordination of where resources are utilized and where those resources are really demanded? And that’s caused by artficially expanding the supply of credit which hides the actual time preference of consumers?

Since according to the scenario, the amount the thief was stealing was never more than the mininum reserves the owner kept anyway, that money could very easily have been loaned out already if the owner kept it at a bank rather than in his house. Not to mention, since we’re talking about physical gold, that same money wasn’t also out driving up prices and claiming resources at the same time like it would in a fractional reserve setup. I don’t see how it would end in a classic boom-bust.

I suppose if the thief got caught, the loans would stop and interest rates would rise again, so I guess there would be some sort of adjustment in the economy, but the earlier projects were still being completed with resources that weren’t already claimed for another purpose, and this rise in interest rates wasn’t a result of a change in consumer time preference, so I would guess the effect would be minimal. But I’m certainly no expert.

• Eric says:

Then again, I could be overcomplicating it. Lower interest rates make a project profitable that wouldn’t be if they knew that money was going to essentially be pulled from the money supply in the future instead of being loaned again or spent.

• guest says:

“Not to mention, since we’re talking about physical gold, that same money wasn’t also out driving up prices and claiming resources at the same time like it would in a fractional reserve setup.”

We’re talking about physical gold being claimed by more than one person at a time. So, one or more of the claims aren’t legitimate – that is, economic decisions are being made by some individuals based on illegitimate claims, rather than on the physical gold actually available.

That’s where the fractional nature of the loan is introduced.

“I suppose if the thief got caught, the loans would stop and interest rates would rise again, so I guess there would be some sort of adjustment in the economy, but the earlier projects were still being completed with resources that weren’t already claimed for another purpose …”

While it’s true that the earlier projects were being completed with resources that weren’t being used by their legitimate owners, the legitimate owners were saving based on their own perceptions of their economic well-being, which means they are ready to spend, or not spend, X amount in their forseeable future, and to spend it on some things and not others.

Prices are affected in one way or another because resources that are being used for one purpose are not available to be used for another.

(Anticipating an objection: if we weren’t talking about resources, we could talk about time being wasted, or on opportunities foregone by those catering to the artificially stimulated projects [as against the opportunities that would have been available, otherwise].) So, there is a limit to how far back the problem can be pushed.)

Losses are being sufferred *somewhere* in the economy as a result of lending other people’s money without their permission. The correction of those losses – however slight – is the bust phase of the cycle.

If, for example, someone enjoys one less sandwich next year than they would have, it may be the case that nobody notices the loss and, by extension, the bust, but the logic of the scenario is that a misallocation of resources has taken place and a bust will occur.

• guest says:

Or, another way of addressing this point is to say that if a saver would change the way he economized his decisions in any way upon realizing that his savings had been lent out without his permission, then that proves he was basing his decisions partly on the belief that his money was secure and sitting at the bank waiting for him at all times.

That’s why lending out someone’s savings without their permission would force the saver into, in effect, making a malinvestment.

(Malinvestments are malinvestments from the point of view of the investor, not of “society” or “the collective”.)

• Eric says:

I see what you’re saying. His consumption is automatically higher than it would be if he knew he was missing some of savings. If he knew, he would stop consuming until he rebuilt it or recovered his stolen funds.

That’s an assumption that he’s already spending more than he needs to though, and will just naturally spend less to replenish the missing reserves. If he can’t spend less than he is, or chooses not to, then it doesn’t change anything. Maybe that’s where the malinvestment comes in, because he’s still consuming at the same rate, and as a result, is claiming that many more resources that won’t be available for the projects started by his investment.

Of course, if there was no thief and he woke up one day and decided to put his gold into a CD, and yet he didn’t change his consumption habits, the same thing would result. So maybe the moral of the story is that yes, this scenario would cause a business cycle, but there are also ways you can bring about business cycles without maliciousness behind the scenes either. Which makes sense, and I don’t remember anyone claiming otherwise.

• guest says:

“… and will just naturally spend less to replenish the missing reserves.”

That’s the bust. If he didn’t make the malinvestment in the first place, he wouldn’t feel the need to replenish missing reserves.

“If he can’t spend less than he is, or chooses not to, then it doesn’t change anything.”

In that scenario, it affects the opportunities he could have had in the future.

He may decide that weathering the losses is sufficiently profitable to continue his current level of consumption, but he now has less for the future.

“Of course, if there was no thief and he woke up one day and decided to put his gold into a CD, and yet he didn’t change his consumption habits, the same thing would result.”

No, because in this case, he has planned his decisions around obstaining from consumption. No business cycle occurs.

“… but there are also ways you can bring about business cycles without maliciousness behind the scenes either.”

Consistent with Methodological Individualism, which says that all actions are taken by individuals, not collectives, yes, in a nuanced and fundamental sense, business cycles can happen without maliciousness.

It’s just that what we normally understand as “the business cycle” involves many businesses failing at around the same time.

But, since they’re all making their malinvestments as individuals, the essence of a boom/bust cycle is simply making a malinvestment and then having to correct for it.