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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.
Maxliberty: If the bank is actually giving out the gold when it is loaned then there are not claims of 190 ounces only 100. If the bank is giving out bank notes when it says it is loaning the gold then you have 190 ounces of claims but that doesn't result in any inherent insolvency. Deposit of 100 ounces. 10 ounces on reserve. 90 ounces are loaned to party A who then uses the 90 ounces to buy a car from party B. The only claim on the 100 ounces of gold is the original depositor. Nobody else has a claim on the gold. Party A owes the bank 90 ounces of gold and party B has the 90 ounces of gold.
If the bank is actually giving out the gold when it is loaned then there are not claims of 190 ounces only 100. If the bank is giving out bank notes when it says it is loaning the gold then you have 190 ounces of claims but that doesn't result in any inherent insolvency.
Deposit of 100 ounces. 10 ounces on reserve. 90 ounces are loaned to party A who then uses the 90 ounces to buy a car from party B. The only claim on the 100 ounces of gold is the original depositor. Nobody else has a claim on the gold. Party A owes the bank 90 ounces of gold and party B has the 90 ounces of gold.
True, but it is 100 oz worth of claims when there is only 10 oz there. The bank is now insolvent unless the stipulated waiting period is in line with the term on the 90 oz loan. In addition, it is inflationary. The claim holders may use those claims for purchases, while the gold holders may use the 90 oz of actual gold in purchases also. So 190 oz worth of gold may now be put to use in various transactions when only 100 oz exists. Business cycle.
Maxliberty: If the bank gives bank notes when they loan out the gold then you have the following: Deposit 100 ounces of gold. 10 ounces on reserve. 90 ounces of bank notes are loaned to Party A who buys a car from Party B. Party B has 90 ounces of claims which he redeems for 90 ounces of gold which leaves a 10 ounce reserve and 90 ounces of loan assets to repay the 100 ounces of the original depositor.
If the bank gives bank notes when they loan out the gold then you have the following: Deposit 100 ounces of gold. 10 ounces on reserve. 90 ounces of bank notes are loaned to Party A who buys a car from Party B. Party B has 90 ounces of claims which he redeems for 90 ounces of gold which leaves a 10 ounce reserve and 90 ounces of loan assets to repay the 100 ounces of the original depositor.
Keep in mind that no bank operates that way. They will actually hold the 100 oz as reserve and create 900 oz worth of certificates to loan out. Anyway, when are the loan assets due to be repaid? Unless they exactly line up with your stipulated delay period, the bank is insolvent. And there are still 190 actual or claims to ounces in existance. So your bank is inflationary. Business cycle.
I sense a theme here. Can anyone tell me what would happen if a contract between two parties is known to harm various third parties by creating the business cycle? What do legal principles dictate? Is it possible that, contrary to this "contracts are everything" libertarian, that some things just can't be contracted? Maybe because they are known to cause 3rd party damage?
Maxliberty: The only thing the Austrians have correct is that if the bank agrees to always hold the gold for the client then the above scenario is not permissable.
The only thing the Austrians have correct is that if the bank agrees to always hold the gold for the client then the above scenario is not permissable.
They also say that time deposit liabilities and assets must be temporally in line. If you have 5 billion in deposits with a contractually stipulated 30 day delay, you have to be able to meet that demand within 30 days according to your balance sheet at all times - not by selling year long notes discounted as an emergency measure to regain solvency in the event that everyone asks for their deposits back. You need to be solvent on your balance sheet at all times which implies that your assets and liabilities have to be in line with regard to time. You have to have money coming in every 30 days to the tune of 5 billion.
You see, the Austrians have you on 2 fronts, one of which you have no hope of winning. Your banking system is inflationary, which means that your deposit contracts are known to harm 3rd parties. No school of economic thought has mounted a winning argument against ABCT. On the second front, you haven't seem to have done a good job arguing, contra Huerta de Soto and traditional legal principles, that your deposit contract is a valid contract. Again, I know you are wedded to the idea that signed contracts are everything. They aren't. When they say A and not A, or when they encourage the various parties to the contract to act as if A and not A are both true, then they are unenforcible and null and void.
dsimo04:I sense a theme here. Can anyone tell me what would happen if a contract between two parties is known to harm various third parties by creating the business cycle? What do legal principles dictate? Is it possible that, contrary to this "contracts are everything" libertarian, that some things just can't be contracted? Maybe because they are known to cause 3rd party damage?
only contracts which cause 3rd party property damage are illegitimate. other damage that is not property damage (so long as its no illegitemate for other reasons) is legitimate. i.e. if two people have a contract that involves one of them disparaging a 3rd parties 'reputation' this involves no property damage and so is legitimate.yet; if the contract involved insulting the 3rd party, by graffitti vandalising the 3rd parties wall with the insult, then this is property damage and illegitimate.
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
GilesStratton: Maxliberty:Why dont we let the market determine that instead of prohibiting it? Is that too much to ask? I wonder if you feel the same way about, say, abortion? Let the market decide? Why is our Truth Bearing One ignoring me, again?
Maxliberty:Why dont we let the market determine that instead of prohibiting it? Is that too much to ask?
I wonder if you feel the same way about, say, abortion? Let the market decide?
Why is our Truth Bearing One ignoring me, again?
Violation of property rights I thought we agreed was wrong. So where property rights have been violated the violator is in the wrong and this should be prevented when possible and punished after the fact.
I have not said we should let the market determine what fraud is only that we should let the market determine if they want to accept time deposits as the equivalent of demand deposits.
Maxliberty:I have not said we should let the market determine what fraud is only that we should let the market determine if they want to accept time deposits as the equivalent of demand deposits.
They cannot be equivalent, by definition.
Now perhaps you can maintain that CDs would be traded instead of money - but only in equilibrium, in which what you suggest would almost certainly be the case.
"You don't need a weatherman to know which way the wind blows"
Bob Dylan
meambobbo: Banks will deal with two sets of time periods in regards to the redemption of time deposits. There is the de facto time period, and the de jure time period. The de facto is how banks actually practice. The de jure is the time are contractually allowed to delay redemption. To make their time deposits function as a money substitute, they would have to reduce at least one of these to a very short period, likely less than on month. But in either case, they are still playing hot potato. When the music stops, there simply won't be enough chairs. (...Yeah, I know I'm mixing children's games...) In a case of de facto demand redemption and a contractual obligation of 3 months, 3 months may seem like enough time for the bank to sell their assets at a pace that does not push down their total price below their obligations. However, by starting to invoke delayed redemption, word will spread about the policy change, all the notes and deposits are less likely to serve as present money anymore. This reduces the amount of circulatory money and must result in lower prices. In the case where it is contractually obligated to redeem its claims within a fairly short period of time, the speed of trying to sell off its assets is likely too rapid, resulting in losses. Each redemption places the bank in a less solvent position. It becomes insolvent long before it can sell off all its assets. The worse shape the bank becomes, the less likely its notes will remain acceptable as present money. Again, this puts deflationary pressure on prices. The banks are insolvent because they cannot sell their assets in exchange for either gold or their deposits, like other market goods. They must sell them for gold only, because they need the gold to pay off the time deposits. The banks must sell for steep discounts from the market price.
Banks will deal with two sets of time periods in regards to the redemption of time deposits. There is the de facto time period, and the de jure time period. The de facto is how banks actually practice. The de jure is the time are contractually allowed to delay redemption.
To make their time deposits function as a money substitute, they would have to reduce at least one of these to a very short period, likely less than on month. But in either case, they are still playing hot potato. When the music stops, there simply won't be enough chairs. (...Yeah, I know I'm mixing children's games...)
In a case of de facto demand redemption and a contractual obligation of 3 months, 3 months may seem like enough time for the bank to sell their assets at a pace that does not push down their total price below their obligations. However, by starting to invoke delayed redemption, word will spread about the policy change, all the notes and deposits are less likely to serve as present money anymore. This reduces the amount of circulatory money and must result in lower prices.
In the case where it is contractually obligated to redeem its claims within a fairly short period of time, the speed of trying to sell off its assets is likely too rapid, resulting in losses. Each redemption places the bank in a less solvent position. It becomes insolvent long before it can sell off all its assets. The worse shape the bank becomes, the less likely its notes will remain acceptable as present money. Again, this puts deflationary pressure on prices.
The banks are insolvent because they cannot sell their assets in exchange for either gold or their deposits, like other market goods. They must sell them for gold only, because they need the gold to pay off the time deposits. The banks must sell for steep discounts from the market price.
This is all just speculation and is certainly not inherently true in all cases. The fact that any business activity is more risky than other business activity does not make it inherently insolvent.
meambobbo:I loan my friend $10, and in exchange he gives me an IOU, due tomorrow. He takes the $10 and buys lunch. I take his IOU and buy lunch as well.
And why would this be prohibited?
meambobbo:In fact, every pair of people in society does this. Well, in this scenario, let's say my friend wants to sell his labor to recoup the $10 and pay me back. His normal day's work is worth $10. Yet, labor prices are adjusted to the supply of dollars + the supply of IOU's. Attempting to sell his labor for $10 will fail if he can only accept dollars, not IOU's for them. The more apparent a preference for dollars over IOU's become, the more the money supply shrinks, and the more difficult it becomes to repay debt as price deflation kicks in.
What everyone else does ain't my problem. I am only on the hook to pay back ten dollars tomorrow.
meambobbo: If nobody spent the IOU's, then your example would hold water, as IOU's would not have any effect on the price structure. And maturations ARE in fact equal in your example - it is implied that your friend is capable of earning $10 by the next day. If your friend requested $1,000,000 for a personal fireworks show and promised to pay you back tomorrow, this would be fraud, as he knows he is incapable of earning $1,000,000 in a day.
If nobody spent the IOU's, then your example would hold water, as IOU's would not have any effect on the price structure. And maturations ARE in fact equal in your example - it is implied that your friend is capable of earning $10 by the next day. If your friend requested $1,000,000 for a personal fireworks show and promised to pay you back tomorrow, this would be fraud, as he knows he is incapable of earning $1,000,000 in a day.
The fact that you might not get paid back tomorrow is part of the risk of loaning money. If you want guarantees about how the loaned money will be used you should put that in the contract not bitch about it later.
GilesStratton: Maxliberty:I have not said we should let the market determine what fraud is only that we should let the market determine if they want to accept time deposits as the equivalent of demand deposits. They cannot be equivalent, by definition. Now perhaps you can maintain that CDs would be traded instead of money - but only in equilibrium, in which what you suggest would almost certainly be the case.
i didn't say they were equivalent just that people could treat them as equivalent.
.
Maxliberty:This is all just speculation and is certainly not inherently true in all cases. The fact that any business activity is more risky than other business activity does not make it inherently insolvent.
i quote myself from another recent thread on the board.
nir: the assets (i.e what they have out on loan) is an income stream that stretches into the future whereas the liablity is what they need to have available for their depositors right now. this means they are taking a long term view. they are insolvent always in the short run, and rely on people not realising so that they can continue to play a little longer. but of course their short run moves along with them, and after enough rolls of the dice they may get found out. then people act suprised that a bank that is 'solvent on paper'(by confusing time (or by confusing property rights!)) isnt solvent in reality.
the assets (i.e what they have out on loan) is an income stream that stretches into the future
whereas the liablity is what they need to have available for their depositors right now.
this means they are taking a long term view.
they are insolvent always in the short run, and rely on people not realising so that they can continue to play a little longer. but of course their short run moves along with them, and after enough rolls of the dice they may get found out. then people act suprised that a bank that is 'solvent on paper'(by confusing time (or by confusing property rights!)) isnt solvent in reality.
a way out is to say that the bank may have *other assets* like they just do banking as a side line and they would be able to meet their contractual obligations to their depositors by dipping into other assets that are not related to their loan assets. but i imagine that will seem like a hollow victory for you.
perhaps to better make your case Max. you will describe the actual 'legitimate contract' you see depositors making with their banks, to allow the kind of banking that you feel is legitimate but then many of us here are skeptical of. please make special reference to Title's over properties spelling out how for whatever commodity is at stake, who has what title at what time and under what conditions. I believe Block does this when he analysis the fraudulent 'duplication over property rights problem' but perhaps you can give an improved *story* that seems superior in contrast to his.
MaxLiberty:I have not said we should let the market determine what fraud is only that we should let the market determine if they want to accept time deposits as the equivalent of demand deposits.
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."
Maxliberty:i didn't say they were equivalent just that people could treat them as equivalent.
No, they cant'.
Juan: MaxLiberty:I have not said we should let the market determine what fraud is only that we should let the market determine if they want to accept time deposits as the equivalent of demand deposits. "accept time deposits as the equivalent of demand deposits"Which is absurd. So you want ppl to voluntarily do something which is absurd. I personally have no problem with it. The contracts stipulating such absurd activity may be regarded as void by legalistically minded ppl but I don't really care. The thing is, in the real world (assuming a free market) your system will not work.
If I offer cash now or an IOU which you can redeem in one second, most people will treat that as the same even though technically it is not.
Anything that is a substitute for the actual thing functions like this. As long as there is the perception that it can be redeemed for the actual gold then the range at which people accept the time deposit as a demand deposit is dependent on the individual person and not you. Have you ever heard of the expression "thirty days same as cash"?
GilesStratton: Maxliberty:i didn't say they were equivalent just that people could treat them as equivalent. No, they cant'.
The word can't means physically unable to do so. Is that what you meant to say?
Max:Anything that is a substitute for the actual thing functions like this. As long as there is the perception that it can be redeemed for the actual gold.
I think we all understand the difference now. I don't understand where the actual harm of FRB is though. If under time deposit people will accept most credits for gold at a later date, then doesn't that have the same effect of FRB?
bigwig: I don't understand where the actual harm of FRB is though
FRB fraudulently creates non-existent property rights. It is also a credit expansion beyond that supported by real savings that leads to the systematic misallocation (squandering) of productive resources and the business cycle.
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bigwig:If under time deposit people will accept most credits for gold at a later date, then doesn't that have the same effect of FRB?
If banks are borrowing short and lending long on time deposits, yes.
Austrians associated with the Mises institute think the business cycle is caused by credit expansion unsupported by real savings. FRB is the most common example of such a credit expansion.
But even without FRB, if banks borrow short and lend long for time deposits, or lend time deposits for longer than they have title (the length of the time deposit), then banks are 1) fraudulently creating non-existent property rights and 2) expanding credit beyond the pool of real savings, leading to a misallocation of resources and a business cycle if the credit expansion is pervasive enough.
I break the rule and reply to you.
Juan:You can produce as much commodity money as you wish. Nobody would object to that...
I am simply challenging the double standard you have. It is good if more money is being produced in face of demand when it is a shiny metal. But somehow it is all evil if it is a different kind of money.
Juan:But it seems you don't fully understand how money works. You seem to advocate the mercantilist fallacy that more money is needed "to make commerce easier" or somesuch and seem to believe that banks issuing tickets is what's needed to fix the 'problem'. You advocate inflation.
Well the optimal amount of money is not whatever currently exists but what matches supply and demand. See?
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