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!
Jon Irenicus:It pertains to the fiat FRB system IIRC, which is already heavily regulated and controlled. I find it peculiar that you argue that under this arrangement there is no fraud nor any multiplication of claims to a given good.
I've tried to point out, perhaps not vehemently enough, that the notes are not property claims, but performance claims, with the implication in my examples that they are "backed" by some combination of reserves and debt assets of a fully solvent bank. Peter Wellington gets at this just below your post.
It is the mistken blurring of the difference that actually leads to the worst problems we have, in that the debt backed liabilities themselves are currently counted as reserves under the assumption that they are true receipts, or property claims, and thus "as good as gold" -and, of course, following on that the elimination of the backing altogether and the counting of pure fiat notes as reserves backing up other fiat notes. In my examples, I hope it was clear that this could not happen and still conform to the contract, but in any case, I'll get to it in more detail later (just taking a short break from work right now).
Jon Irenicus:you do not make enough of an effort to differentiate the two, which I think increases people's hostility here to your arguments.
Probably.
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.
PeterWellington: hjmaiere, Arguing that the practice of FRB is evil because it has been mis-used is like arguing guns are evil because they have been mis-used. [...]
hjmaiere,
Arguing that the practice of FRB is evil because it has been mis-used is like arguing guns are evil because they have been mis-used.
[...]
As I've tried to point out several times, the argument is not that FRB is evil and should be outlawed. The argument is that fractional-reserve banking won't happen, and never has happened under conditions that lack fraud or coercion. You can issue all the Peter's-Fractional-Reserve-Bank-Notes (PFRBNs) you want. I don't care. People, as a rule, won't use them as money.
There are praxeological reasons why this is the case. Money is anything used to facilitate indirect exchange. In theory, almost anything that someone somewhere values can function as money. So I suppose it is possible that someone somewhere sometime might use a PFRBN as money, just as it is possible that someone somewhere sometime might use a chicken, or a Shania Twain CD as money.
In practice, certain things have certain qualities that make them serve really well as money: portability, divisibility, fungibility, durability, and market demand independent of its function as money. Absent coercion, markets tend to settle on precious metals for use as money, because they satisfy all of these qualities.
There were situations where people found it more convenient to trade warehouse receipts for gold in place of the gold those warehouse receipts represented. But, those situations were contrived and depended heavily on the trust placed in the institutions that issued those warehouse receipts. In the case of PFRBNs, they might be a great way to save money and make a little interest, but even in purely non-fraudulent conditions, backed by 'safe' investments (which, back when these things were called 'shares' included things like house loans ironically enough), there is little reason people would accept these things as money. There's zero reason to think that a competing bank would accept them as money. Banks accepted the notes of competing banks out of a duty to customer service, but they redeemed them for specie or their own notes as immediately as possible. There's no way they would ever consider them an asset against which they could issue further deman-deposits.
In short, the notion of fractional-reserve banking under truly free-market conditions really is absurd once you think it through.
I agree with most of what you wrote about money, but I don't agree that FBR under a free market is absurd. I think we already see several similar practices in our market today that were not brought about by government (as DriftWood and I have mentioned). Let's take a company that does world-wide business insuring home owners against fire damage. Do you require that the company be solvent in case of some type of monumental disaster that burns down 90% of the homes on the planet? Personally, I wouldn't demand that, but you may. I would take advantage of lower rates while you would pay more for peace of mind. In other words, as long as the insurance companies are divulging this information, there's no fraud and the market can decide. The same can be said of FRB.
It seems as though the belief that FRB isn't viable stems from the notion that wealth is somehow being created out of thin air. The only thing being created out of thin air are the notes promising to deliver gold (or whatever other commodity is being used). Real wealth can be created over time. If we consider gold as a form of wealth, then the simplest example would be prospecting for and finding gold. This makes it possible to pay back loans with interest without anyone getting screwed over. But "finding gold" can be replaced with any productive activity that creates value.
This is why FRB isn't a Ponzi scam. It's based on statistical behavioral patterns of depositors and borrowers, matched in such a way that it's unlikely there will be a conflict (when managed properly), much in the same way as insurance companies operate.
PeterWellington: hjmaiere, I agree with most of what you wrote about money, but I don't agree that FBR under a free market is absurd. I think we already see several similar practices in our market today that were not brought about by government (as DriftWood and I have mentioned). Let's take a company that does world-wide business insuring home owners against fire damage. Do you require that the company be solvent in case of some type of monumental disaster that burns down 90% of the homes on the planet? Personally, I wouldn't demand that, but you may. I would take advantage of lower rates while you would pay more for peace of mind. In other words, as long as the insurance companies are divulging this information, there's no fraud and the market can decide. The same can be said of FRB.
No, your analogy is flawed. Fractional-reserve banking presumes far more than merely that Peter's-Fractional-Reserve-Bank-Notes (PFRBNs) be of value. That's not in question. It presumes that PFRBNs will serve as a money—as a medium of indirect exchange. That's the absurd part.
Money (by the Austrian definition) is anything that facilitates indirect exchange. If someone accepts something in trade not because they intend to consume it (in the economic sense), but because they intend to trade it for something else, that thing is functioning as money. As I said, things that are portable, fungible, divisible, durable, and have value independent of their use as money tend to serve well as money. Together, these properties could be described as remarketability. (Economic text books will add that money is used as a unit of accounting and a store of value. But this is only a cororllary of their use as a common medium of exchange.)
For Peter's Fractional Reserve Bank to practice fractional-reserve banking, it must have the ability to issue pieces of paper (representing shares on the bank's assests) as if they were money. This requires not only that regular people accept these pieces of paper as money (which is absurd), but that other competing banks accept them as money (which is doubly-absurd).
If a bank accepted the bank note of another bank as if it were money, it would be favoring the other bank (which is making double interest on a title to real money) at its own expence (whose assets now include risky titles to another bank's outstanding loans). And no customer of a bank is going to allow a bank to redeem its notes in some other bank's notes. It simply will not happen.
But this provides insight into the true function of a central bank. If by law there is one and only one legal kind of bank note, then banks are no longer in competition with each other for the trust of their depositors. The banks have effectively been cartelized. The banks win, and by no coincidence, the government wins, because (at least originally) the primary legal way to create new bank notes out of thin air was to 'buy' government securities.
PeterWellington: [...] This is why FRB isn't a Ponzi scam. It's based on statistical behavioral patterns of depositors and borrowers, matched in such a way that it's unlikely there will be a conflict (when managed properly), much in the same way as insurance companies operate.
Can you provide a single example from history where fractional-reserve banking operated under free-market conditions in the way you describe?
hjmaiere:Can you provide a single example from history where fractional-reserve banking operated under free-market conditions in the way you describe?
Can you let me know in what countries and in what time periods you consider free markets to have existed?
I know we're going back and forth a little here, but the most important thing to me is the issue of force/fraud. I think we both agree that we don't want a government or anyone else forcing a currency or bank notes on us. It seems like you also agree that FRB practiced in a free market with complete and honest disclosure is not fraud (putting aside the issue for a moment of whether or not people would actually partake in it). Please correct me if I'm wrong there.
If that's the case, then the debate over FRB being feasible is interesting, but really a moot point as the market will decide, as neither of us would forcefully interfere.
I think our main point of contention is the use of these notes as money.
hjmaiere:Fractional-reserve banking presumes far more than merely that Peter's-Fractional-Reserve-Bank-Notes (PFRBNs) be of value. That's not in question. It presumes that PFRBNs will serve as a money—as a medium of indirect exchange. That's the absurd part.
hjmaiere:So I suppose it is possible that someone somewhere sometime might use a PFRBN as money, just as it is possible that someone somewhere sometime might use a chicken, or a Shania Twain CD as money.
If you look back on my posts, I've consistently said that these types of notes would not function as gold itself (or whatever), but merely as a promise to deliver gold. I think our only real disagreement is what value these promissory notes would have. You think the gold/PFRBN parity would be huge, I think it would be fairly small for a trusted, well-run, and honest bank that completely discloses the nature of the notes. Again, the market would decide.
PeterWellington:If you treat a promise to pay one ounce of gold as you would an actual ounce of gold, then that's on you.
That is the presumption behind the issuance of the note.
PeterWellington: Anonymous Coward:Oh, and I wouldn't equate the airlines with a free market system by any stretch of the imagination. The airlines are heavily regulated, but it's a cop-out to dismiss anything related to the airlines without looking at how regulation affects the issue. The government is not forcing airlines to overbook flights. There is nothing that's preventing airlines from stopping this practice yet it continues.
Anonymous Coward:Oh, and I wouldn't equate the airlines with a free market system by any stretch of the imagination.
The airlines are heavily regulated, but it's a cop-out to dismiss anything related to the airlines without looking at how regulation affects the issue. The government is not forcing airlines to overbook flights. There is nothing that's preventing airlines from stopping this practice yet it continues.
The fact that a practice continues does in no way reflect the validity nor the morality of said practice, just look at taxes.
Bit of a red herring anyway hence the reason I dismissed it out of hand.
PeterWellington: [...] If you look back on my posts, I've consistently said that these types of notes would not function as gold itself (or whatever), but merely as a promise to deliver gold. I think our only real disagreement is what value these promissory notes would have. You think the gold/PFRBN parity would be huge, I think it would be fairly small for a trusted, well-run, and honest bank that completely discloses the nature of the notes. Again, the market would decide.
But if PFRBNs are not fradulent, then they are not a promise to deliver gold. They are merely a claim on the assets of a bank (i.e. its outstanding loans and investments). This is not a promise to deliver gold. A bank may offer to buy that PFRBN from you when it can (that is, 'redeem' it when it can), but it is not, and cannot legally be a promise to deliver gold on demand.
More importantly, none of this has anything to do with the gold/PFRBN parity. It might occasionally be the case that PFRBNs preserve and even grow wealth better than gold, at least over time. That's completely irrelevant. PFRBNs still won't trade as money any more than any other equity will. People don't trade Google stock as money. The reason is because it takes too much localized knowledge to know the true worth of PFRBNs at any given moment. It takes a long time for something to broadly establish people's trust in its remarketability and thus allow it to serve as a medium of exchange. It took the touchstone for gold to establish itself as a truly practical medium of exchange. And there is a huge accounting advantage to using a common medium of exchange. For PFRBNs to displace gold as a common medium of exchange, it needs to be more remarketable than the gold it supposedly represents. And this is logically impossible.
You need to really understand what money is to understand why PFRBNs won't be money under non-fradulent, non-coerced conditions. Money is not merely an asset. It is not merely a (present or future) claim on an asset. It is a medium of exchange, and this something very very different.
hjmaiere:But if PFRBNs are not fradulent, then they are not a promise to deliver gold. They are merely a claim on the assets of a bank (i.e. its outstanding loans and investments). This is not a promise to deliver gold. A bank may offer to buy that PFRBN from you when it can (that is, 'redeem' it when it can), but it is not, and cannot legally be a promise to deliver gold on demand.
Couldn't the same be said of a non-fractional reserve bank? Let's say there's a new bank in town that has 5 ounces of gold reserves. You deposit 10 ounces of gold and it provides you with 10 notes, each can be redeemed for an ounce of gold at any time. If it lends your 10 ounces of gold to a borrower, you would only be able to redeem 5 of your notes until the loan was paid off. In other words, you can't redeem all your notes on demand as promised. And who's to say the loan will be paid off? What if the borrower defaults? Aren't you, in essensce, holding a fractional reserve note now?
hjmaiere:You need to really understand what money is to understand why PFRBNs won't be money under non-fradulent, non-coerced conditions. Money is not merely an asset. It is not merely a (present or future) claim on an asset. It is a medium of exchange, and this something very very different.
But you've said that anything of value can technically function as money. So what we're really debating is the degree of remarketability. Again, this is very difficult to determine. Your opinion may be closer to the truth, who knows, it's up to the market to decide and again, if you wouldn't use force to stop such a practice then I think all's well and good.