Fractional reserve banking question

meambobbo:

Yall need to cut Histhasthai and Driftwood some slack.  They are essentially correct.

They are ethically correct. But there is a hugely important point about why fractional-reserve banking is praxeologically impossible on a sustained basis absent fraud or coercion. Anonymous Coward pokes at it in his most recent post to this topic with his point about fractional-reserve bank notes being an arbitrage opportunity. But I think I have one more way to make the point, based on why I think people think fractional-reserve banking can work.

Warehouse receipts for gold can trade in place of gold because someone paid the warehouser to store the gold. They effectively paid for the service of redeeming that warehouse receipt for gold. Let's call this the 'redemption service' associated with the warehouse receipt. The value of a warehouse receipt includes more than the gold it represents. It also includes the value of this 'redemption service.' Not everyone will think this 'redemption service' is worth the risk of not accepting the gold directly. But some will under some circumstances based on the trust they place in the issuer of the warehouse receipt and convenience of dealing with the receipt in place of the gold.

People who think fractional-reserve banking can work think this warehousing fee can simply be replaced with the income generated from lending out some portion of the contents of the warehouse at interest. But here's the important point: In the case of the warehouse receipt, the person trying to use the warehouse receipt as money has already paid for the 'redemption service' up front. The person receiving the warehouse receipt does not pay for this redemption service in the form of risk, and is thus more likely to accept the warehouse receipt in place of the gold it represents.

Okay, now let's talk about checking accounts. What the defenders of free-market fractional-reserve banking really seem to be talking about is checkbook money. That is, a bank offers to 'store' your money, but really pays you a fee for the lending opportunities you have given the bank by 'storing' your money with them. You 'redeem' checkbook money by writing a check. But here's the thing: checkbook money doesn't really function as money unless and until the check is cashed and the bank pays for the 'redemption service' either by directly redeeming the check for gold, or indirectly, by paying for the warehousing of gold itself. People only accept a check in payment for something based on their confidence that the bank will be able to successfully pay for this 'redemption service.' In a free market, paying for something by check will be far less common. It will only happen in the case where the person or institution receiving the check trusts both the person offering the check and the institution responsible for redeeming it. And as I alluded to earlier, a competing bank will redeem such a check as absolutely quickly as possible, because it will reduce the competing bank's cash on hand and increase its own.

The point is that in the case of both warehouse receipts and checkbook money, the agent who wants them to serve as money has to pay for their 'redemption service' up front.

 

Fractional-reserve banking implies that either checkbook money be treated as money, or that bank notes be treated as money. But this in turn implies that the person receiving the check or the bank note be burdened with the cost in tems of risk of the 'redemption service' associated with the check or the note. Praxeologically, the check or the note will never trade at face value against the 'real' money it supposedly represents, and consequently will never displace that 'real' money as money

This is such an important point because, as you allude, the bankers will pretend that the role of government is to police this supposedly natural and legitimate market phenomenon, when in reality the role of government is to make it work (by coercion) in the first place.

meambobbo:

I believe Mises himself wanted to allow competitive FRB, as he thought that was the only means to keep banks from keeping insufficient reserves.  100% reserve requirement would mean the government could just as simply litigate a 50% or a 1% reserve requirement...then bail them out with tax money if they faced a bank run.  If the market were in charge, individuals would manage the risks and rewards of FRB in the case of individual competing banks.

Yes, the most important thing is that banking and government are separate, but I hope I've finally explained that if the market were in charge, individuals would manage FRB out of existence

meambobbo:

And bank werehousing still exists, if you want to do that instead of time deposits, fractional reserve demand deposits, or physical possession: they're called safety deposit boxes.

Safety deposit boxes are not a good analogy for bank warehousing. 'Digital precious metal operators' are, and the government is doing everything it can to make those illegal.

 

I confess that after reading 120 posts I still don't understand how fictional reserve banking works.

I gave up on this discussion.  It felt like someone was squeezing my head like a grape.

 

The way i see it, the different types of gold deposit notes, are really just different type of gold debt instruments. Either the bank owes and stores gold directly in wich case the debt is only between you and the bank. Or the bank trusts the gold to some 3rd party, in wich case the debt is still between you and the bank, but there is also a debt between the bank and the 3rd party. You could probably use both of these gold debt instrument in trade, an their  value would be close to that of gold, if the traders trusted that the bank actually owned or could easily get the gold needed to exchange the gold debt into real gold.

Anyways, im going to pimp "that site" once more. I read the book "Gold: the once and future money" and it really changed my mind.. about how all this money and banking stuff works. The author on his blog can be a bit rude and "takes a piss" out of austrians at times.. but dont let that distract you. Here are a couple of posts that in some sense relate to this thread.

"Does Debt Creation Cause Inflation?"

http://www.newworldeconomics.com/archives/2006/030406.htm

"Fractional Reserve" Banking

http://www.newworldeconomics.com/archives/2006/070906.htm

 Different Kinds of "Money"

http://www.newworldeconomics.com/archives/2007/090207.html

The "Money Multiplier"

http://www.newworldeconomics.com/archives/2007/102007.html

etc..

Cheers

I think the only thing getting the piss taken out of it is people's patience...

Money, properly identified as base money, is not created in the lending process, but by the central bank.

...

Inflation is caused by a decline in currency value, measured in an absolute sense, which is done by comparing the value of currencies to gold. If there's a decline, you've got some sort of inflation. No decline, no inflation.

Today, of course, banks do not print money. Central banks "print" the money, but do not make loans, while banks make loans, but do not print money. However, given this historical precedent, it is not too hard to see how a careless sort of analyst could accuse banks of "inflating the money supply" by "making loans," all of this because the bank was a "fractional reserve bank."

This was a time when commercial banks were engaged both in credit creation and money creation, oftentimes in a single act...  This confusion is what gave rise to the idea that credit creation is a type of money creation, and since we know that excessive money creation leads to a loss in monetary value, i.e., inflation, well, danger danger!

All monetary transactions take place with base money, which is literally coins or bills, or bank reserves. (There is another point of confusion here in that a redeemable bill does have a counterparty, in the sense that the issuer is legally required to deliver bullion on demand. For our purposes, since there is little real difference between a redeemable bill and an unredeemable one as long as base money supply is being properly managed, we will consider them the same and both forms of base money.)

Ok, that's the gist of the argument.

Oh, and that a bank deposit is really a loan to the bank, not a 'demand deposit', and so can't be considered as 'money in the bank' for economic calculation purposes.

This is probably why Mises uses the term 'fiduciary media' so strawman arguments such as this don't topple the whole of Austrian economic theory. But I suppose you and your favorite economists already knew that and took it into account when posting the same old circular arguments over and over.

In Mises' own words;

In issuing fiduciary media, by which I mean bank notes without gold backing or current accounts which are not entirely backed by gold reserves, the banks are in a position to expand credit considerably. The creation of these additional fiduciary media permits them to extend credit well beyond the limit set by their own assets and by the funds entrusted to them by their clients. They intervene on the market in this case as "suppliers" of additional credit, created by themselves, and they thus produce a lowering of the rate of interest, which falls below the level at which it would have been without their intervention.

I have a question: why is it that all these guys, a lot of them cranks, try to take the "piss" out of the Austrians? What do they gain from it? Personal satisfaction? Are their lives really that pathetic? Poor silly little jokers. I'd say maybe Austrians should also adopt such puerile behaviour, but it'd be degrading. I find it humorous, seeing as a number of Austrians themselves advocate free banking. From this entire argument, I've seen nothing that disagrees with the Austrians on their core theories, only disagreement on whether FRB is correct or not. So why he feels the need to "take the piss out of the Austrians" is beyond me. What is perhaps more humorous is that no effort is made to separate fiat FRB from the free market proposed alternative. Personally I have no problems with free banking, but I do have problems when fiat money is conflated with it and treated as equally unproblematic.

-Jon

DriftWood:

The way i see it, the different types of gold deposit notes, are really just different type of gold debt instruments. Either the bank owes and stores gold directly in wich case the debt is only between you and the bank. Or the bank trusts the gold to some 3rd party, in wich case the debt is still between you and the bank, but there is also a debt between the bank and the 3rd party. You could probably use both of these gold debt instrument in trade, an their  value would be close to that of gold, if the traders trusted that the bank actually owned or could easily get the gold needed to exchange the gold debt into real gold.

Economics is not merely about getting the accounting right. The one thing the Austrian School understands that way too many other people don't seem to understand is that economic phenomenon is, at its core, the product of people acting to attain ends.

Just because a piece of paper represents some kind of claim on gold doesn't mean it will function as money in place of gold, which is what fractional-reserve banking presumes. A piece of paper may represent a legitimate contract that says the bank must pay you gold under some described circumstance, and consequently that piece of paper may have genuine value in the market place. But value alone does not determine what will function as money in the marketplace.

A piece of paper representing a claim on gold stored in a warehouse will only trade in place of gold under very specific circumstances. A piece of paper representing a mere promise to pay gold is so profoundly different than actual gold that the chance that it will trade in place of gold as money is vanishingly small. I mean, be honest with yourself. If you're trying to sell something to someone, and one person offers you a one-ounce gold coin, and another person offers you a piece of paper issued by a bank you may or may not have heard of that represents a promise to pay you gold that you know they may or may not have at the time, which are you going to accept?

From the first article DriftWood cites:

"If, for some reason, the legal obligation to redeem these possibly excess banknotes into gold (typical in the 19^th century) could be avoided in some way, as was common in the Western and Southern states in the US for example, then the banknotes would lose value compared to their gold parity and the situation would become inflationary."

This is completely wrong. The bank notes didn't lose value because a person was less likely to be able to redeem them for gold. They lost value because there were more of them bidding for the pool of goods and services that existed at the time. That's why fractional-reserve banking is always inflationary in the sense that prices are always higher than they otherwise would have been. Prices may stay steady during expansion of the money supply, as they did in the 1920s, but all that this means is that without expansion of the money supply, prices would have gone down to reflect the fact that there were more goods and services for that money to bid for.

More from the article:

"Many people today claim that debt creation causes an increase in the 'money supply,' although this is incorrect. Money, properly identified as base money, is not created in the lending process, but by the central bank. Central banks can create base money, but not debt (unless they use the discount window perhaps, which is extremely rare). Commercial banks (and all other lenders or issuers of bonds) can create debt, but not base money. As we noted two weeks ago, most measures of "money", such as M2, M3, or MZM, are in fact measures of cash-like debt. So, to say that debt creation creates debt (M2, M3, MZM) is not very interesting."

This completely ignores the fact that when a bank hands you a Federal Reserve note, you have no way of distinguishing whether it is "base money" or whether it is debt-backed money. And this is by design. Fractional-reserve banking requires that someone who accepts a bank note either not know whether it represents a title versus credit (because of fraud), or not be allowed to distinguish whether it represents a title versus credit (because of legal tender laws).

When people are able to distinguish between a title to gold, and credit to be repayed in gold, the latter will not function as money, and consequently fractional-reserve banking will not happen under free-market conditions.

 

I didn't bother to read the rest of the articles.

Says Mr Lewis :

"When certain nominally "Austrian" types want to get all medieval on you, they start to talk about "fractional reserve banking," which is an antiquarian term for what we now call "banking." Banks today (and for the last few centuries) are intermediaries: they borrow from depositors and make loans to borrowers, and pocket the "spread" between the two interest rates."

I wonder what's a 'nominal Austrian' ? What is to 'get medieval' ? Oh he admits that the current system is FRB ? But then claims FRB is not really FRB but a legitimate system to channel real savings ?

What puzzles me a bit is that his book seems to have been published by Bill Bonner's company...

Juan, there is no such thing as fictional reserve banking - even our fiat money is backed by something (although far not enough so maybe you're right).  It is backed by the federal government's ability to tax our future economy.  That's what backs the debt it sells to the FED in return for new money...and that new money backs all the fractional reserve banking of the FED's members.

This is essentially where things like fractional reserve banking and fiat banking are villified.  Some debtor cannot pay his debt, and that debt gets put onto people who had nothing to do with it.  This is not true with investments and loans funded by genuine credit - ie, claims on real goods already produced, as the risk is inherent in the loan.  In that artificial credit is created on the contention that some future real goods will be produced, it is unlimited by current wealth, and when institutionalized as in America and most of the world through central banking, it only means that everyone's wealth is on the line.  This inherent risk that can be passed onto 3rd parties is a tremendous violation of free market principles, and I believe this is why Austrians are so hateful towards these practices.

I would like to qualify that while I said fractional reserve banking, in and of itself, was not a bad thing, I meant it in the sense that banks practicing such could not be bailed out with artificial credit/money and were fully policed by the market without protection of the government.

FRB is an "antiquarian" term? My econ textbook uses it, and it's not even Austrian. What is this guy on about? I still want to know whether FRB as practised by the government is legitimate or not, and whether it differs from FRB as practised in a free market, because it is the former the Austrians focus on, and it has repeatedly been asserted by Driftwood that the Austrians are "wrong" on FRB (perhaps some are wrong that FRB is inherently fraudulent, but that is neither here nor there with regard to the current governmental FRB system) - but I see these links reference banking as it is now, which is not free banking. Sounds like sheer nonsense to me.

-Jon

Juan, there is no such thing as fictional reserve banking - even our fiat money is backed by something (although far not enough so maybe you're right).

But that's exactly the nature of fraud. There can be no fraud if a minimum of 'backing' and 'faith' are missing. That is, the system seems to work - indeed does work for a time...until it breaks down because some of the 'promises' can't be kept.

If I want to cheat somebody, I need to build some 'trust' first. And to do so I must act in a legitimate way...for a time. Now, when my victim has lent me enough money, I can default on my obligations.

Some debtor cannot pay his debt, and that debt gets put onto people who had nothing to do with it. This is not true with investments and loans funded by genuine credit - ie, claims on real goods already produced, as the risk is inherent in the loan.

Right, but that's not FRB - that is 'ordinary' banking ? I think that calling the system based on genuine credit FRB is causing at least part of the confusion in this thread ? Or perhaps there's more than one claim per good ? In that case we have indeed FRB...and problems.

I would like to qualify that while I said fractional reserve banking, in and of itself, was not a bad thing, I meant it in the sense that banks practicing such could not be bailed out with artificial credit/money and were fully policed by the market without protection of the government.

I think we agree that FRB shouldn't be banned, and that FRB can be wholly 'contractual'. Still it will not work. As a matter of fact. it didn't work and that's why FR bankers came up with central banking.

meambobbo:

Juan, there is no such thing as [fractional] reserve banking - even our fiat money is backed by something (although far not enough so maybe you're right).  It is backed by the federal government's ability to tax our future economy.  That's what backs the debt it sells to the FED in return for new money...and that new money backs all the fractional reserve banking of the FED's members.

[...]

This isn't what 'backs' Federal Reserve notes. I know it's the 'official' story, but as stated it doesn't even really make any sense. Why would the government's ability to demand magic tokens from taxpayers in the future to pay back the magic tokens it borrows now (created out of nothing by the Federal Reserve) in any sense "back" them? We're supposed to think that the Federal Reserve is merely a manifestation of some collective decision we as a society have made that 'dollars' serve as money.

But it's a massive con job.

Federal Reserve notes are valuable because if you don't come up with enough of them to pay your taxes, the government with take your stuff and throw you in jail. This makes Federal Reserve magic tokens extremely valuable, and what make it possible for them to serve as money in place of the gold they once represented. Turns out this trick is an old one:

http://www.kitco.com/ind/saville/jun202006.html

And the difference between fractional-reserve banking and 'mere' banking is that when you lend your gold to a 'mere' bank who further lends it out to someone else to collect interest on it, the piece of paper they give you that says you lent them your gold isn't traded as money in the place of the gold it supposedly lays a claim on. In a free market, there's no reason to think it would any more than any other I.O.U. It really isn't that complicated were it not for all the nonsense spewed out to obfuscate the issue.

 

Juan, I am not sure I understand what ordinary banking is by these terms.  If I put 1 oz of gold in the bank, and they lend out .5 oz, that's fractional reserve banking, but they're using real wealth to make their loans.  The bank doesn't want to cheat anyone (well, maybe those wildcat banks...).  It may become insolvent, which would happen quickly if it had to maintain trust in the face of competition while operating at low reserves and making risky loans.

Otherwise, I completely agree with you.  We have to be clear, however, that there is a difference between fractional reserve banking and issuing unbacked bank notes.  FRB, in using real wealth, is limited in issuing credit until it holds a 0% reserve.  Unbacked notes have no limit.

meambobbo:

[...] If I put 1 oz of gold in the bank, and they lend out .5 oz, that's fractional reserve banking, but they're using real wealth to make their loans. [...]

Whether this is fractional-reserve banking depends entirely on the piece of paper they hand you in exchange for depositing the gold with them. If they give you a certificate of deposit, it is not fractional-reserve banking.

meambobbo:

[...] We have to be clear, however, that there is a difference between fractional reserve banking and issuing unbacked bank notes. [...]

Fractional-reserve banking is by definition issuing unbacked bank notes. An outstanding loan does not "back" a bank note.