I was reading a debate between two people who disagreed on whether fractional reserve banking was bad. I wanted to get to the root of why it is bad. Would it be correct to say it's only bad to the extent that it requires the central bank to print more money to meet redemption requests? For example, if I deposit $100 in a bank that lends $90 of it to someone who spends it on a product and the seller of the product then deposits the $90 in another bank, as long as I don't redeem my deposit before the loan is repaid, the central bank doesn't have to print money and lend it to my bank in order to repay me, right? Or is this an impossible situation because the loan cannot be repaid without some sort of monetary expansion in order for the borrower of the $90 to cover the interest that accrues on the principal? Thanks!
fsk:The bank can't pay. It has an immediate obligation of 1000 ounces of gold but only 100 ounces gold on hand. There is no guarantee that the bank will be able to sell its loan porfolio for the 900 ounces of gold owed depositors. For this reason, a fractional reserve bank offering demand deposits is committing fraud.
For this reason, a fractional reserve bank offering demand deposits is committing fraud.
Jeezus Christ, can anybody have an original thought here? Realized risk is not evidence of fraud. If you loaned me money to start a business, and the business fails, have I committed fraud?
Your characterization of "lottery ticket" assumes a run is already underway. That's the risk being realized, not the cause of the run.
fsk:The fraud is that the fractional reserve bank is borrowing at the overnight demand rate, but lending at the long-term rate.
Wait, are you saying that making a profit is fraud? I don't get where this in and of itself even touches on any issue of FRB.
fsk:Before limited liability incorporation was legalized by the US Supreme Court, a banks' owners and management would be responsible for any shorffall.
Yup. And that's the way it would be with private banking FRB, though they may be able to purchase insurance.
fsk:In a truly free market, where government violence won't intervene to protect fractional reserve bankers, fractional reserve banking is not a sustainable business. You'd have to be a fool to deposit your gold in a fractional reserve bank. You would prefer an Austrian-style warehouse receipt bank or time deposit bank.
So you know what my risk preference would be? So tell me, what flavor of ice cream is objectively best? The claim that it would be an unsustainable business, despite it's repetition here ad nauseum, remains an unsupported claim. Not necessarily false, merely unsupported so far.
fsk: In a truly free market, banking is not evil.
Obviously. Still, it entirely begs the question of whether FRB qualifies as evil.
The state won't go away once enough people want the state to go away, the state will effectively disappear once enough people no longer care that much whether it stays or goes. We don't need a revolution, we need millions of them.
histhasthai: [...] hjmaiere:The simple historical fact is that without government intervention, people simply didn't treat that piece of paper as if it were money, including the issuing bank itself. I'm not prepared to argue historical banking in detail, but several otherwise solvent banks failed on liquidity crises, prior to the Federal Reserve and the FDIC. Such failures would imply FRB, else a solvent bank could not fail. [...]
[...]
hjmaiere:The simple historical fact is that without government intervention, people simply didn't treat that piece of paper as if it were money, including the issuing bank itself.
I'm not prepared to argue historical banking in detail, but several otherwise solvent banks failed on liquidity crises, prior to the Federal Reserve and the FDIC. Such failures would imply FRB, else a solvent bank could not fail. [...]
Why should the failure of a bank be viewed as somehow a more tragic incident than the failure of any other business? Why should the Federal Reserve's ability to protect its member banks from the ravages of competition in the marketpace be considered a good thing? The creation of the Federal Reserve has definitely helped its member banks survive every economic crisis since its formation. But us plebeians have, since its creation, had to put up with the single biggest economic depression in the history of the world, not to mention a 95% devaluation (at least) of the dollar. Why is government intervention designed to prop up banks at the expense of everyone else some thing the average joe should consider a good thing? Yes, I can be sure of being able to pull my money out of my checking account any time I want, but food and gasoline are up in price by somewhere between 15% and 30% year over year.
What makes banks sacred?
And note: The claim is not that fractional-reserve banking should be made illegal. The claim is that fractional-reserve banking won't happen under free-market conditions. Nothing you have written addresses this point.
histhasthai: liberty student:Fractional banking receipts are lottery tickets, So does that mean I can discount you from any further serious discussion on the matter?
liberty student:Fractional banking receipts are lottery tickets,
So does that mean I can discount you from any further serious discussion on the matter?
You can do whatever you want. It seems you have been in this discussion.
FRB receipts are like lottery tickets. When you exchange them for face value, there is a statistical chance you will receive nothing.
I would make a great bureaucrat. Wanna see? Click here. It's fun.
What I'm learning here is that the opposition to FRB is, on this board at least, little more than dogma recieved from Murray or whomever
What would be nice, however, is either a substantive and convincing refutation of FRB,
or a concession that it is a matter for the markets to decide.
A dumb question: are you guys talking of two fractional reserve systems? It seems to me like a bank that creates banknotes for which they have no backing is a different practice than working out short-time deposits to provide for long-term loans...
Originally, the issue with the Federal Reserve was that they provided more bank notes than they had gold, right? But nowadays, the issue is they take the risk away from this business, irresponsibly creating money in the process, correct?
Equality before the law and material equality are not only different but are in conflict with each other; and we can achieve either one or the other, but not both at the same time. -- F. A. Hayek in The Constitution of Liberty
"That's not FRB. That's ordinary borrowing/lending."
It is. Most of you guys still are abit confued about what the purpose of banks are, and how fractional reserve banking is the most efficient free market way for banks to work. Imagine a world without a central bank and were gold coins are used as money.
Banks exist to connect borrowers and lenders. Its the middle man, so that borrower dont have to go looking for lenders and vice versa. Banks are not warehouses. A warehouse can not lend out anything, it can only store stuff. If you stored gold with a warehouse, you can get out the gold on request, but you would have to pay it a storage fee. If you payed the storage fee, with some of the gold you had stored.. it would work like a negative interest, your stored gold would grow smaller and smaller. This is why warehousing gold or money is not a popular option.
The free market came up with a better way.. it came up with the concept of a bank. What do savers want? To be able to get back their gold on request, and not pay much of a storage fee. What do borrower want? To get to borrow money on the long term, and not pay much of a fee for doing so. Fractional reserve banking is the method that makes all short term savers, into long term lenders. Its a wonderful free market innovation. Savers deposit their money with a bank, as long as the bank does not break the contract of giving back the money on request the savers are happy. The bank does not charge the savers a fee, they pay them a fee (interest). Imagine that, all those gold warehouses went bust because they could not compete with a sweet deal like that. So the bank lends out the money on the long term to borrower and are able to charge a lower interest (than regular long time lenders). So the bank makes money on the spread between the interset it pays to the savers/lender and the borrowers. This whole scheme, of the bank borrowing short term money that has to be repayed on request.. and lending it out on the long term that will not be repayed on request, works because as a whole, statistically, many short term savers works as one long time lender. Savers rarely take out all their money. People more often keep their money with a bank than carry it around in a wallet. As long as the bank does not brake its contract of redemability on request, it has not doen anything wrong.
You see, fractional reserve banking is a win win situation. Savers dont have to pay a fee, lenders can loan out money on the short term instead of on long term. Borrowers can loan out money for a smaller fee. Lots of economic progress could not have been doen as quickly, if it had not been for this wonderful market invention. Seriously, we all benifit. If you have a good business idea you can start up a profitable comnpany by getting a loan. You dont have to pay cash for your house.. you can easily get a relatively cheap mortage. You dont have to pay a fee to keep your money safe. etc. It works remarkably well. Most banks are over a hundred years old.
It only works however as long as borrower are able to pay back the money and the interest. So bank have to be careful who it lends out the money to. It can lend out money to risky borrowers as long as it charges a big interest on those loans., that way if one risky borrower is not able to repay, it is compensated by the ten risky borrowers that did.. and who paid the high interest fee.
This system works fine even without a central bank.. or without any paper money. Remember all that i have described so far is fractional reserve banking in a gold coin system. The banks have little or no reserves. It lends out any money that it has borrowed, it keeps little or no reserves, thats the whole point of a bank.
If the bank is badly run and it borrows out money at a low interest to risky borrowers.. well then it will not be able to repay the depositors on request and it will have broken its contract and trust. It will go bankrupt. The savers will loose some of their money. A central bank can bail out the savers by covering the banks losses. Its the bailing out of savers by the govt that is wrong, not fractional reserve banking,
You fractional reserve banking makes lenders out of savers. Borrowers abviously benifit, and savers benifit by getting payed interest. The reason why there are no money warehouse around anymore is because savers rather saves their money with a bank that pays them interest, rather than with a warehouse that charges them a fee. Its a free market thing, warehouses got competed out of existance.
Cheers
DriftWood:Its a free market thing, warehouses got competed out of existance.
A bank crash is a big concern for consumers -- that's why banks used to take reputation seriously, and used to build imponent buildings to demonstrate how well they were doing -- so I think that without government protection, you'd still see some warehouse-like banks, or at the least low-interest but high-reserve offerings.
Anyway, thanks for the explanation. I guess that nowadays banks concerns over risk is just to maximize profits, not because they are concerned about losses, since they will just be rescued, right? If a bank gets robbed is it also rescued? Here, I've seen only once a bank loss because they bought another or something. Usually, they are always growing and growing. Other than the fixed costs, when can they actually lose money?
About the only way a bank can loose money is if they calculate the risk involved with borrowers wrong. Interst is the price of borrowing money. So if they start charging the same interest for high risk borrowers, like a homeless junkie, the same price as they charge low risk borrowers like some big company.. then they are asking for trouble. Thats what they did with the current subprime mess. I remeber seeing lods of adds on TV.. "Cant get a loan? We will give you one, no questions asked. Only 7% interest." When noname banks on TV shops starts selling loans.. well we should have known *** was about to hit the fan.
So what happens with all those depositors when a bank fails? Well they can sue the bank for contract violation, when they cant repay the money on request. Somewhere in the contract you signed when you opened up your deposit account its, said something like we promise to repay you your money on request. However nowhere in the contract does it say what the bank can do with the money in the meantime. To be honest, you dont care what they do with it aslong as they have it when you request it. so after the bankrupcy court.. you probably still wont get all your money back.. because they lost it already.. the govt might be tempted to pay you back the difference but this is really bad. If they keep doing that.. banks will start loaning money out on the cheap to homeless junkies, because they dont care if the borrower is able to repay the loan or not, as long as the govt pick up any loss.
Well back to it.. I think the biggest reason people have got the idea that fractional reserve banking is evil.. is because of this idea of the "money multiplier". Yeah we all heard about it in that movie.. "money as debt". The reasoning goes something like this: "Did you know, banks loan out 50 times as mouch money as they have in the reserves?" That sure sounds like banks are multiplying money, that they are creating money out of thin air. And if they can create 50 times as much, why not a thousand, or a billion? It sounds like there is no end to the madness. The govt should regulate this abomination now!
Well the reasoning sounds reasonable but isnt.. there is no connection between the size of the reserves and the amount of loans a bank has made. The reasoning should be "Did you know that a bank lend out 98% of the deposited money". This might still sound abit scary, but it is clearer that there is a limit, and that there is no money creation invloved. A bank can not lend out more money than people deposit with it. So at most it can lend out all of it, thats the limit. After it has lent out all the money, it cant lend out any more. It cant create any money. Looking at it this way and you might start to realize that maybe fractional reserve banking is not such a evil thing after all, and that the govt does not need to regulate it.
A banks that lends out to high risk borrowers, will have to have a big reserve.. to guard against lots of defaults. A bank that only borrows out to millionaires.. and profitable companies.. well it needs little reserves. And if a bank found itself short of reserves.. and people who demanded their deposits out. Well the bank could raise money by selling its assets. What assets does a bank have? I has lots and lots of people that pay interest on their mortage every month. Its basically got lots of bond that pays 6% interest. It can sell enough of those to raise money.
As long as a banks borrowers are sound.. a bank will be able to survive a bank run. Only badly managed banks have to worry about bank runs.
You do agree though that government protection allows banks to keep far less money on reserve than what would prevail on a market, right? And it is still the case that government-aided FRB is a form of price control, setting the price too low in most cases.
-Jon
I cannot be caged. I cannot be controlled. Understand this as you die, ever pathetic, ever fools.
Irenicus' Diaries.