I have given thought to this and I can't find any a priori demonstration that fractional reserve banking is bad. Sure, it multiplies money in the economy and may create inflation, but it might very well be equilibrated with the investment-spending-saving behaviors of the people.
I usually check any issue by asking if it violates some hardcore axiomatic principle, but I can't think of any principle violated by fractional reserve banking.
People who deposit money in a bank already know the money will be used for loans. If they had a problem with that they would put the money in a safe box instead. So there is no moral problem involved.
Then there is the inflationary issue.
Some guy deposits money in the bank, the bank will pay a fee to the first guy (being a intermediary) and could lend all the money at a higher fee to someone else. The second guy uses it to buy a new car for his taxi company. The car dealer will pay for his expenses (including buying more cars) and deposit the rest of the money. The car manufacturer, at his time, will pay his expenses and deposit the surplus. The same will happen with every other person who becomes and indirect receiver of the loan. Most of the money will be flowing through the market, only a small part will be saved. An equilibrium will be achieved sooner or later. The bank (if it expects to recover the money) can only lend to people with guarantees and projects that have a sound plan, which are scarce. The surplus of money in any economy is scarce too. The lending doesn't go on ad infinitum, it will stop at a point that depends on the current situation of the economy.
The only problem could occur when someone doesn't really want to loan the money, but just it keep there to facilitate the handling of money by issuing checks instead of having to carry (for example) gold or silver with him all the time. Then he agrees to pay a fee to the bank, and expects to be able to withdraw the money at anytime. If the bank makes loans using that money then the banker really is committing fraud. Otherwise, he is not.
The issue really comes down to sound banking practices. Fractional reserve, as based in fixed term deposits, isn't immoral at all. The danger for any person making a deposit would be the same as if he was lending it directly to some friend. His friend's project may fail and he may have to execute the guarantee, maybe will lose his money, maybe will have to go to a trial to recover something.
Actually, informal loans could be considered banking operations with a zero-reserve.
So, what's the problem? What am I missing here? Why is everybody against it?
Pity the theory which sets itself up in opposition to the mind!
Carl Von Clausewitz
gussosa: The only problem could occur when someone doesn't really want to loan the money, but just it keep there to facilitate the handling of money by issuing checks instead of having to carry (for example) gold or silver with him all the time. Then he agrees to pay a fee to the bank, and expects to be able to withdraw the money at anytime. If the bank makes loans using that money then the banker really is committing fraud.
The only problem could occur when someone doesn't really want to loan the money, but just it keep there to facilitate the handling of money by issuing checks instead of having to carry (for example) gold or silver with him all the time. Then he agrees to pay a fee to the bank, and expects to be able to withdraw the money at anytime. If the bank makes loans using that money then the banker really is committing fraud.
What you have just described as "fraud" is fractional reserve banking.
gussosa: The issue really comes down to sound banking practices. Fractional reserve, as based in fixed term deposits, isn't immoral at all.
The issue really comes down to sound banking practices. Fractional reserve, as based in fixed term deposits, isn't immoral at all.
"Fractional reserve, as based in fixed term deposits" doesn't make any sense.
It's the fractional reserve system, not fiat, that's the problem - in theory, you could have 100% reserve banking with fiat money, and it wouldn't be a problem. I'm just saying it doesn't make sense to talk about "fractional reserve" on term deposits (even in a strong 100% reserve system, term deposits would have "0% reserves" - it doesn't make sense not to loan that out)
bigwig:If there aren't bank runs (99% of the time), doesn't it mean that depositers would not touch that money and thus allow it to be loaned out in a free market?
Not necessarily, because money can be transferred from one account to another without being withdrawn and redeposited - i.e., it doesn't have to exist to be used in payment. Given Internet banking, etc., a modern bank could allow you to specify how much you want to keep on demand for immediate use and let you put different amounts in various-length term deposits (e.g., they could offer 24 hour, 7 days, 30, 60, 90 days, 6 months, 1, 2, and 5 years, say), where they'd offer continuously varying higher or lower interest rates on each length depending on their need for loanable funds, etc. (I mean the offered rate would vary perhaps several times a day; once you committed some money to it, you'd get whatever rate was offered at that time); when you put some money into, say, a 7 day account, it would disappear from your current balance and be returned (with interest) 7 days later (you could have some sort of calendar display showing your future balances as well as the current balance) - now the banks could legitimately loan out your money (with no reserve requirement!), except whatever you keep on demand (for which you'd pay a fee), and hardly anybody would keep any significant amount on demand, and bank runs would be impossible. But that's not what they do today.
Anonymous Coward: If you were to put your chair in a warehouse on the contractual condition that it will be returned when you ask for it you have just opened a 'demand deposit' account with that warehouse. What do they do, they charge you money to watch your chair. Now if you were to go try to pick up your chair and they told you that you have to wait 60 days because they leased it out you would be a little upset and accuse them of fraud, wouldn't you?
If you were to put your chair in a warehouse on the contractual condition that it will be returned when you ask for it you have just opened a 'demand deposit' account with that warehouse. What do they do, they charge you money to watch your chair.
Now if you were to go try to pick up your chair and they told you that you have to wait 60 days because they leased it out you would be a little upset and accuse them of fraud, wouldn't you?
It is only fraud if you are told they are not going to lease the chair out and then they do and you don't get the chair when you demand it. I could easily create a bank that had an insurer guarantee the demand deposits and then use the guarantee to minimize the cash on hand. The only obligation is to provide you the money on the terms we have agreed.
Anonymous Coward: There is nothing inherently wrong about banks loaning out money that they get specific permission from the owner like a CD or savings account where it is understood that the money isn't part of your current cash holdings and treated as such.
There is nothing inherently wrong about banks loaning out money that they get specific permission from the owner like a CD or savings account where it is understood that the money isn't part of your current cash holdings and treated as such.
Isn't the bank under the same obligation to pay you when the CD matures? What happens when the CD matures and they don't have the money? Is that fraud? The only difference between the CD and the demand deposit is that the CD has a specific maturation date and the demand deposit matures at the time the depositor chooses. Once you understand that time is money then the length of time is irrelevant.
What you want is not a bank but a safe.
Maxliberty:Once you understand that time is money then the length of time is irrelevant.
Huh?
Money is a good the same as the chair.
Mises' regression theorem, anyone?
Not to be condescending or anything but do you make this stuff as you go or have you read anything on this site?
Anonymous Coward: Maxliberty:Once you understand that time is money then the length of time is irrelevant. Huh? Money is a good the same as the chair. Mises' regression theorem, anyone? Not to be condescending or anything but do you make this stuff as you go or have you read anything on this site?
The point is whether I use your money for one second or one year I am still obligated to return it to you at the given time. A demand deposit is nothing more than a shortened loan period. The whole purpose of banking is to receive money and then loan money out.
Maxliberty: It is only fraud if you are told they are not going to lease the chair out and then they do and you don't get the chair when you demand it. I could easily create a bank that had an insurer guarantee the demand deposits and then use the guarantee to minimize the cash on hand.
It is only fraud if you are told they are not going to lease the chair out and then they do and you don't get the chair when you demand it. I could easily create a bank that had an insurer guarantee the demand deposits and then use the guarantee to minimize the cash on hand.
No you couldn't. Nobody with any sense would underwrite that. Insurance only works with quantifiable risks; you're asking them to insure against an event of unknown probability and impossibly huge payout.
Paul: Maxliberty: It is only fraud if you are told they are not going to lease the chair out and then they do and you don't get the chair when you demand it. I could easily create a bank that had an insurer guarantee the demand deposits and then use the guarantee to minimize the cash on hand. No you couldn't. Nobody with any sense would underwrite that. Insurance only works with quantifiable risks; you're asking them to insure against an event of unknown probability and impossibly huge payout.
Of course you could insure demand deposits. There is X amount of demand deposits that is the total risk possible. It is very quantifiable and easily insured.
February 17 - 1600 - Giordano Bruno is burnt alive by the catholic church. Aquinas : "much more reason is there for heretics, as soon as they are convicted of heresy, to be not only excommunicated but even put to death."
Anonymous Coward: Eduard - Gabriel Munteanu:The law does not allow full-reserve banking. More specifically, banks have to keep a certain fixed reserve, and this reserve must be kept in the central bank, if I remember correctly. There's nothing stopping a bank from instituting 100% reserve banking it's just that they have to compete with all the other banks.
Eduard - Gabriel Munteanu:The law does not allow full-reserve banking. More specifically, banks have to keep a certain fixed reserve, and this reserve must be kept in the central bank, if I remember correctly.
There's nothing stopping a bank from instituting 100% reserve banking it's just that they have to compete with all the other banks.
Hmm, you're probably right. I looked it up further and I saw nothing about limiting excess reserves. It looks like last-resort-lender policies and all that stuff makes full reserve a lot less profitable.
As a side note, contracts in which gold is used as currency are unenforcable [1]. But this pertains to the gold standard.
[1] http://en.wikipedia.org/wiki/Executive_Order_6102 (last paragraph, as of writing this)
Maxliberty: Of course you could insure demand deposits. There is X amount of demand deposits that is the total risk possible. It is very quantifiable and easily insured.
If you have insurance for something that will pay out, say, $1000, and the insurance company knows the probability of having to pay out is, say, 1%, it knows it'll have to pay out on average $10 per client (per year, or whatever), and charge its clients appropriately. If you have insurance for bank deposits, the insurance company has no way to estimate the probability of default - I suppose the only sensible thing it could do, if it wants to survive, would be to assume it's 100% - so the cost of insurance would be equal to the total of the bank's deposits (or at least the insured portion)...but it only has a small fraction of that amount, by definition, and needs that to support the customers until the inevitable default arises...
Paul: Maxliberty: Of course you could insure demand deposits. There is X amount of demand deposits that is the total risk possible. It is very quantifiable and easily insured. If you have insurance for something that will pay out, say, $1000, and the insurance company knows the probability of having to pay out is, say, 1%, it knows it'll have to pay out on average $10 per client (per year, or whatever), and charge its clients appropriately. If you have insurance for bank deposits, the insurance company has no way to estimate the probability of default - I suppose the only sensible thing it could do, if it wants to survive, would be to assume it's 100% - so the cost of insurance would be equal to the total of the bank's deposits (or at least the insured portion)...but it only has a small fraction of that amount, by definition, and needs that to support the customers until the inevitable default arises...
Of course you can estimate the probability of default. The insurer would know where and for what the bank is lending money. Are you really trying to say there is no way to measure credit risk? That is all we are talking about.
Eduard - Gabriel Munteanu:As a side note, contracts in which gold is used as currency are unenforcable [1]. But this pertains to the gold standard.
I thought Dr. No, err...Ron Paul changed that when it became legal for US serfs to own gold again.
Maxliberty:Of course you can estimate the probability of default. The insurer would know where and for what the bank is lending money. Are you really trying to say there is no way to measure credit risk? That is all we are talking about.
Are there any real insurance plans out there that insure a loan against default?
I know they have things like CDS but those aren't insurance policies per se.
This is what you're really talking about here, loan insurance and not deposit insurance because there is no way to do a 1:1 deposit to loan matchup when it's all about 'money management' as you like to claim.
It is also quite telling that the FDIC is the only form of deposit insurance out there since the private sector won't touch it with a ten foot pole. They didn't privatize an already existing plan but had to make it up all on their own with the taxpayer being ultimately responsible for backing the deposits in case all the insurance runs out.
Insurance companies aren't too keen on the whole 'privatize the profits and socialize the losses' when they're the one who are paying for the socialism and their customers are getting all the profits.
I have a mission for you Max, find us a historic free market banking system with both fractional reserves and insured deposits that was 'free' in the sense that they couldn't suspend specie payments or get any other kind of bailouts when things went bad.
Shouldn't be too hard if such a system is possible...
I'd also like to see an example of an insurance plan where the risks are directly tied to the activities of the insured but I know that no such animal exists.
Maxliberty: Of course you can estimate the probability of default. The insurer would know where and for what the bank is lending money. Are you really trying to say there is no way to measure credit risk? That is all we are talking about.
I meant the bank defaulting, not whoever it's lending money to (but you probably can't do the latter, either)
Anonymous Coward: Maxliberty:Of course you can estimate the probability of default. The insurer would know where and for what the bank is lending money. Are you really trying to say there is no way to measure credit risk? That is all we are talking about. Are there any real insurance plans out there that insure a loan against default? I know they have things like CDS but those aren't insurance policies per se. This is what you're really talking about here, loan insurance and not deposit insurance because there is no way to do a 1:1 deposit to loan matchup when it's all about 'money management' as you like to claim. It is also quite telling that the FDIC is the only form of deposit insurance out there since the private sector won't touch it with a ten foot pole. They didn't privatize an already existing plan but had to make it up all on their own with the taxpayer being ultimately responsible for backing the deposits in case all the insurance runs out. Insurance companies aren't too keen on the whole 'privatize the profits and socialize the losses' when they're the one who are paying for the socialism and their customers are getting all the profits. I have a mission for you Max, find us a historic free market banking system with both fractional reserves and insured deposits that was 'free' in the sense that they couldn't suspend specie payments or get any other kind of bailouts when things went bad. Shouldn't be too hard if such a system is possible... I'd also like to see an example of an insurance plan where the risks are directly tied to the activities of the insured but I know that no such animal exists.
What you fail to factor in is that loaning money out is profitable. If the profit rate is greater than the default rate then the deposit which is backing the loan can be insured. This is how insurance works.
The problem with fractional reserve banking is not whether it is profitable nor whether the bank can perform some cash management hocus pocus capable of preventing a run nor even whether the depositors know that their money is being held under a fractional reserve system.
Fractional reserve banking is fraud because in a given moment of time two or more people each have a claim to 100% of the existing goods. If the depositor knows this, the only difference is that he is a willing party to the fraud commited against everyone else.
A time deposit does not have this problem, during the period of the deposit the depositor has no claim to the money, after the term the bank has no claim to the money.
Hoppe, Hulsmann and Block provide a more detailed explanation in Against Fiduciary Media.
The negative effects of FRB are just a symptom, allowing systematic fraud leads to economic problems - it should not surprise anyone who thinks in principles.
The good old FRB debate.
Merging two world views into one theory creates a seam. It is at this seam that a new theory is weakest. The reason this debate always pops up is because it hilights a criticial weakness in the seam sown by Murray Rothbard in his merger of Austrian economics with libertarianism.
Traditional austrian economics via Mises provides a sound economic critique of FRB. Libertarianism, on the other hand, espouses the primacy of contract. According to the libertarian, if two consenting adults choose to enter into an FRB style contract no one can forcibly prevent them from doing so. This denial and acceptance of FRB puts the austrian economist and the libertarian at odds.
Sowing together these two intellectual edifices with their differing opinions on FRB is therefore impossible, though Rothbard has attempted to do so (as has De Soto), usually through long and drawn out legalist arguments. There is such a panopoly of debates on this subject on Mises.com because it's pretty easy for many to see through Rothbard's weak seam; the inherent contradiction between Austrianism and libertarianism. At the same time, the anti-FRB fire control crowd comes to parrot Rothbard and man the weak link. Fireworks ensue.
On the whole, Austro-libertarians just need to accept the FRB weak-link as the price to pay for uniting two grand theories. To assume an entire intellectual edifice to be coherent and non-contradictory is sheer silliness.
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