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This is a rephrasing of an earlier question that kind of veered off into 'is fractional reserve banking a fraud' direction. I'm studying Austrian Economics and trying to understand how a full reserve banking system avoids the business cycle when time deposits seem to suffer the same shortcomings as fractional reserve banking. So let me present my understanding of how money is created in a fractional banking system, how time deposits work in Austrian Theory, and hopefully someone can point out where I have taken a wrong turn.
In Fractional Reserve Banking, money is 'created' when a bank loans out a deposit and that deposit finds its' way back into the banking system to be loaned out again, minus the fractional reserve requirement. For example, a $1000 deposit in a 10% reserve requirement system supports an initial loan of $900. That loan finds its way back into the banking system when the borrower purchases whatever and the sellers deposit the proceeds. There is now an additional $900 in deposits, supporting $810 in loans, which goes through the same cycle until the original $1000 deposit supports a total number of loans equivalent to ( $1000 + $910 + $819 + etc) = $10,000. More accurately, it is probably a little less as at each iteration some of the money is held as cash.
In Austrian Economics there is no lending of demand deposits, only time deposits. Presumably, there is no reserve requirement for time deposits though it doesn't really matter. Now let's say someone walks into a bank with a lucky $1,000 gold piece with what looks like a horse shoe scratched into its face. He deposits the coin into a one year time deposit and goes off on his merry way. A couple of minutes later, the bank loans this $1,000 gold coin to a customer, who goes out and purchases an ice cream machine with that coin. The ice cream machine maker rushes over to the bank and deposits the lucky $1,000 gold coin into a one year time deposit. Seconds later, the bank loans the same coin to another customer who runs out and uses the lucky coin to put a down payment on an organ grinder. The organ grinder maker rushes over to the bank and deposits the same coin into a one year time deposit. Moments later, the bank lends the very same coin to a customer who hires a barber to give him the world's most awesome haircut, the same one John Edwards got. The barber then rushes to the bank and deposits the lucky coin, which the bank loans out.
It seems to me that this one lucky coin and one deposit of $1,000 is ultimately supporting the same pyramiding of loans as fractional reserve banking and the same creation of money limited instead of by fractional requirements, the amount that each person decides to hold in demand deposits instead of timed deposits and could be greater or lesser depending on the preference for time deposits to demand deposits.
If this is the case, then we are in fact back at the same starting point of credit creating money and therefore the business cycle.
So my question is what am I missing or getting wrong in Austrian FRB Theory? Someone referenced Soto earlier implying that this was a correct understanding, but I don't pretend to know. I'm just trying to learn. Can anyone help me here and give me some direction? Thanks.
scineram:They can and do. I bet you if tomorrow I go to the bank and withdraw all of my account they will pay me.
Are you done being a pedant? You know full well that I meant they cannot be sure of that.
scineram:Nonsense.
Prove it.
scineram:All of you have a very idiosyncratic concept of fraud. Just ask Kinsella.
What's wrong the definition provided? And yes, thank you, I've read Kinsella.
"You don't need a weatherman to know which way the wind blows"
Bob Dylan
meambobbo:A bank distributing options-claused notes would be required to hold assets that matured just as quickly or were incredibly liquid. Otherwise, there is no indication the bank was acting purposefully to consistently honor its contracts - this is fraud.
Yes, it is a question of liquidity not whether the bank is holding 100% specific redemption commodity.
meambobbo: If the bank is operating on the probability that it only needs to fulfill a fraction of its contractual obligations, it is operating fraudulently. It is not taking actions to ensure it is able to meet its obligations as they fall due. This is true for both time deposits and demand deposits.
If the bank is operating on the probability that it only needs to fulfill a fraction of its contractual obligations, it is operating fraudulently. It is not taking actions to ensure it is able to meet its obligations as they fall due. This is true for both time deposits and demand deposits.
Absolutely right.
meambobbo: If the bank makes an error of judgment, such as making a loan that defaults, this is not fraudulent. This is the risk depositors must take. If the bank simply refuses to match assets and liabilities, decidedly playing a game of hot potato, it is operating fraudulently. This is not the risk depositors signed up for.
If the bank makes an error of judgment, such as making a loan that defaults, this is not fraudulent. This is the risk depositors must take. If the bank simply refuses to match assets and liabilities, decidedly playing a game of hot potato, it is operating fraudulently. This is not the risk depositors signed up for.
Correct again. Exactly what I have been saying.
GilesStratton:You know full well that I meant they cannot be sure of that.
Prove that is true in all cases that we have discussed anymore than 100% reserve banks.
MaxLiberty:Yes, it is a question of liquidity
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."
of course the bank can not know what price other assets (aside from those orginally deposited by the depositors) might fetch on the market should the bank need to reimburse any subset of customers, so it takes an unnecessary risk that if not explicitly agreed to with customers (involving explicit limited liability and the like) constitutes intentional negligence. lack of duty of care. active fraud.
Where there is no property there is no justice; a proposition as certain as any demonstration in Euclid
Fools! not to see that what they madly desire would be a calamity to them as no hands but their own could bring
Maxliberty: Yes, it is a question of liquidity not whether the bank is holding 100% specific redemption commodity.
Haha, do bank runs, the Fed, and the FDIC Insurance Act mean nothing to you? Put the pieces together. Not maintaining 100% reserves creates the necessary conditions that lead to a lack of liquidity. It's like insuring something a person can control, it simply isn't viable--thus, government must step in.
You're hopeless.
By the way, if your mind is even remotely still open, read de Soto's book. He answers and refutes all of your hopeless arguments.
Haha, do bank runs, the Fed, and the FDIC Insurance Act mean nothing to you?
I just wanted to pop in again. I've been reading De Soto but he is very long-winded. The thing I am interested in is the business cycle. The 'fraud' topic really doesn't interest me at all. As long as expectations are set and depositors know what they are getting into, I don't see how it could be fraud. I know when I deposit money in to a bank that it is going to be there unless there is a bank run and the governement decides not to pay out on deposit insurance. It is a risk I understand, and judge to be so small that I don't worry about it. Now, if things go really bad, I might reassess. But it is no secret to me, or anyone who bothers to look, that the bank is going to lend out my deposit.
I'm not commenting on the way it should be, only the way it is now. I also don't mean to tell others not to discuss the possibly fraudulent nature of Fractional Reserve Banking. I just want try to understand how FRB and time deposits effect the business cycle. It would help if Austrian Economics wasn't so averse to real life examples. Can anyone tell me what a fifth order good might be? I think a weedeater might be qa second order good, but I can't even get that confirmed so far.
But thanks for all the comments so far. I appreciate them.
I know when I deposit money in to a bank that it is going to be there unless there is a bank run and the governement decides not to pay out on deposit insurance. It is a risk I understand, and judge to be so small that I don't worry about it. Now, if things go really bad, I might reassess. But it is no secret to me, or anyone who bothers to look, that the bank is going to lend out my deposit.
morganja:I just want try to understand how FRB and time deposits effect the business cycle. It would help if Austrian Economics wasn't so averse to real life examples.
You're not reading the right sources. Try Rothbard. He did historical analysis, which should satisfy your needs for "real world" examples. Also articles @ mises.org by Bob Murphy and Mark Thornton may help you.
If you find something evil that wobbles, push it. - Gary North
morganja:Can anyone tell me what a fifth order good might be? I think a weedeater might be qa second order good, but I can't even get that confirmed so far.
Well, I would think a fifth order good for one product might be a second order good for another. For example, take glass. It can be a consumer's good, used as a window. It could also be part of a microscope, used to deliver research, to create technology, etc. I would think raw materials would easily be a higher order good. Thus, the capital goods required to mine, refine, and mold them would all be even higher order goods.
Yeah, a weedeater is a capital good, used to get a nice looking lawn, a consumer good...unless you just enjoy weedeating .
morganja:I just want try to understand how FRB and time deposits effect the business cycle.
When money supply increases through the credit market, usually and most powerfully through FRB, this first drives interest rates down. This normally allows investors to invest in long-term projects that will not generate any income for a pro-longed period of time. A lower interest rate also indicates increased savings, meaning there is more current production than current consumption. In our modern economy, most of this investment is directed towards extending the production structure, developing new capital goods that allow business to operate more efficiently. This takes time.
In normal circumstances, a drop in the interest rate means that people are saving more, which would mean more consumer goods are being created than are being consumed, at normal prices, quantities, and profit margins. When businesses borrow the money savings from banks and spend it on their investment projects, the workers and related industries spend much of the money on consumer goods. Consumer demand slumps a little, but at the same time marginal resources are shifted away from producing consumers goods to working on higher order goods due to the investments. In this way the economy balances itself along with time preference. If people increase their savings, this drives down the interest rate and makes long-term investments that increase productivity more profitable than short-term ones that expand retail stock. Also, more production is devoted to future consumption, allowing current production and consumption to match again.
However, if FRB is responsible for lowering the interest rate, several things go wrong. First, interest rates do not represent time preference. Marginal savers now become consumers or speculators. Thus, there is no decrease in consumer demand, and high production levels of consumer goods will remain profitable. This, along with the increased money supply, causes investors to face higher and higher costs for their projects, facing competition for resources from both other investors and an expanding existing production structure. Naturally, many investors are not prepared for or cannot gauge these cost increases. Some will find themselves stuck in an unprofitable investment and be forced to liquidate. Others may wish to complete their project, but they will require more credit. Should the interest rate rise before extending their credit, they will also be shown to be unprofitable. The larger the FRB and distortion of interest rates, the higher they'll need to go to be in line with time preference, and the greater the number of business failures. To try to keep pressing on and on despite declining savings rates and price inflation will lead to wild speculative bubbles and a currency collapse.
If time deposits truly represent a loan, not an alternate form of present money, they are not an increase to the money supply, and they will not cause a business cycle. If they are simply a higher-interest demand deposit, especially if convertible into other fractionally backed bank money, they are part of the money supply, will effect business cycles, and can cause business cycles. It seems to me that banks wouldn't make loans by entering time deposits into someone's account. But I guess they could. In any case, they could loan via demand deposit, and the borrower could simply convert what he didn't need to be instantly liquid into a time deposit. Thus, as long as they can increase without corresponding real savings, they can cause a business cycle.
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nirgrahamUK:this would depend on issues of liability which would be established at the outset. sometimes the bank might be liable sometimes not, depending.
I should have clarified. If the bank's loan fails but the bank does not fail, it will likely be obligated to fulfill your time deposit. But there is the chance the bank may fail, and it may not have enough assets to filfull its obligations to you. This was the risk I was refering to. I was assuming we still have today's limited liability for businesses.
edward_1313:Not maintaining 100% reserves creates the necessary conditions that lead to a lack of liquidity.
Only with demand deposits. He is refering to a note with an option clause I believe, which would be a time deposit. His argument is that if the bank is going to run the risk of having all its notes turned in at once, it must purposefully maintain an asset portfolio that will either mature or can be liquidated at > the price of its liabilities in less time than the option clauses permit denial of redemption.
However, I think his other point is that the notes should be used as money, in addition to the gold, which I assume is lent out. Thus, this is inflationary and would likely cause business cycles, with interest rates detached from savings rates. For the money to remain usable as money, however, the option clause could not be invoked. Once it was, this would likely be highly deflationary, lead to massive loan defaults, and render the bank insolvent anyway. I would think it would be an error not oft repeated in a free market.
Maxliberty:This can be demonstrated and has been that a non100% reserve bank can honour all of its agreements.
Yes, nor has that been disputed, however, that cannot be assured, as it can with 100% reserve banks (assuming no unexpected events).
Maxliberty:You can't guarantee the bank will never be robbed.
And? The fact is, by its own actions the FRB bank sets in motion events that will put its liquidity in danger.
Maxliberty:This is just your assertion. You can not prove that the exmples I have provided are inherently fraudulent.
Nor need I, the examples you've provided do not represent FRB. You've just said that the bank who makes a demand deposit contract with its customer must honour its obligations, now you're saying it needn't. Which is it?
Maxliberty:Yes, it is completely relevant, probablity versus impossibility is very important.
When you assure your customers that you will always be able to meet your obligations what matters is that you have not, by your own actions, done anything to make that impossible. FRB makes it impossible that you will always be able to, in all events and circumstances (that you can foresee), honour your obligations. So no, you're wrong.
Maxliberty:People do have time preferences but if those time preferences can be so small that they are for practical purposes irrelevant for decision making purposes. For example it is hard to calculate the discount for accepting a dollar now or in one second. This is an example of the failure of your demand deposit definition, it doesn't really exist because the piece of paper isn't gold but we would agree you are accepting it as if it is despite the time preference delay from receiving actual gold.
Yes, time preference may be negligible, but other things being equal they will rather sooner goods than future ones. Moreover, they will rather a good which they can be sure to have over one that is inherently risky, such as the CD you mention. It is up to you to make sure the ceteris are not paribus in order to make you're case, which as of now you're not even attempting.
As for the demand deposit, you miss the point. The bank note for a demand deposit is a perfect money substitute, it is perfectly liquid. You can redeem it in demand for the same amount of money that the note says. This is not possible with a time deposit in which they is going to be a waiting period, moreover, you cannot be sure that that you will be able to redeem it within two hours unless the loan matures at that time.
Maxliberty:You can not prove that they will be unable to honour their contracts and FRB as you have defined it doesn't really exist, it is dependent on your arbitrary definitions and once those definitions can be demonstrated to be inherently false then your arguement falters.
FRB is exactly how I've defined it and that is how it has historically existed. My argument falters? No, you're just attacking a strawman because FRB is, by definition, the misappropriation of demand deposits.
And no, I don't need to prove that they will, under all circumstances, fail to meet their obligations. You're shifting the burden of proof inappopriately, it is you that must prove that the FRB bank will always be able to honour their obligations. And when I say FRB bank, I mean exactly that, I do not mean that you can call whatever contract you desire "fractional reserve banking", since that label refers to a specific arrangments, one in which a bank grants loans out of its demand deposits.
Maxliberty:What I am achieving is demonstrating that your definitions are arbitrary and unsustainable and as such can not be the basis for prohibition of anything in a free society. If you look at the example I provided to ninghram you can see a demonstration of the impractical nature of your definitions and how they would not limit banks as you propose they would in a free society.
There is a great difference between a DD and a TD. In the former the contract is one for the purpose of safekeeping, no future goods are being exchanged for present goods. The notes are redeemable on demand. In the latter, the contract is made for the specific purpose of exchanging future goods for present goods, moreover, the notes are not redeemable on demand. Or, more specifically, the bank , in order to meet its obligations, needn't make the notes redeemable on demand.
edward_1313: Maxliberty: Yes, it is a question of liquidity not whether the bank is holding 100% specific redemption commodity. Haha, do bank runs, the Fed, and the FDIC Insurance Act mean nothing to you? Put the pieces together. Not maintaining 100% reserves creates the necessary conditions that lead to a lack of liquidity. It's like insuring something a person can control, it simply isn't viable--thus, government must step in. You're hopeless. By the way, if your mind is even remotely still open, read de Soto's book. He answers and refutes all of your hopeless arguments.
Yes, we should agree that the arguement will have to be settled with violence in a free society. You and your group will attempt to use violence to stop my bank as I have described it and I and people like scineram will use violence to prevent you from doing so. I will not be convinced what is clearly not fraud is fraud nor are you going to change your position.
So violent resolution is the only option.
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