Fractional reserve banking question

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!

this link will explain why it is bad

anonnymous:

this link will explain why it is bad

 I don't think your link came through.

here it is

http;//fskrealityguide.blogspot.com

The short answer is that fractional-reserve banking is bad because it's a way for banks to make money by lending out and investing money they don't really have, and for governments to spend money without the political inconvenience of taxing people for it or borrowing it from willing lenders. The consequence is chronic, systemic rising prices and so-called business cycles as the wealth of the economy is transfered to the bankers and the politically connected. Central banks also happen to play a facilitating role in financing wars of agression.

The reason most people don't understand all this is because the plutocracy has had a hundred years to put into place institutions whose purpuse is to obscure the true function of central banking:

http://www.lewrockwell.com/north/north632.html

And the true nature of government is revealed in the fact that even the most populous of politicians will never allow this wholesale transfer of wealth from poor to rich to even enter sanctioned political discourse (Ron Paul being the exception, of course).

hjmaiere:

The short answer is that fractional-reserve banking is bad because it's a way for banks to make money by lending out and investing money they don't really have, and for governments to spend money without the political inconvenience of taxing people for it or borrowing it from willing lenders. The consequence is chronic, systemic rising prices and so-called business cycles as the wealth of the economy is transfered to the bankers and the politically connected. Central banks also happen to play a facilitating role in financing wars of agression.

The reason most people don't understand all this is because the plutocracy has had a hundred years to put into place institutions whose purpuse is to obscure the true function of central banking:

http://www.lewrockwell.com/north/north632.html

And the true nature of government is revealed in the fact that even the most populous of politicians will never allow this wholesale transfer of wealth from poor to rich to even enter sanctioned political discourse (Ron Paul being the exception, of course).

well said andwhen the depression comes they will deny that they were the cause, party line and all.

Fractional reserve banking is a free market invention. It would exist even under pure cold coin system. It has nothing to do with central banks or inflating money supply. If you lend me money, on the promise that you will get back the money on request.. i can do whatever i want with the money in the mean time. I can lend it out or invest it. As long as Invest it profitably as opposed to waste the money. I will be able to give you back your money on request. Fractional reserve banking is lending out short term loans to long term borrowers. It works because many short time lenders, as a whole behave as one long time lender. As long as the bank does not lend out money to people who will not be able to pay back.. the bank is sound and everyone that has lent the bank its money will get back their money.

If a bank is unsound.. if it lent out money cheaply (low interest loans) to low quality, high risk lenders.. well then the bank will be insolvent.. and it will go bankrupt unless some govt institution bails it out. Its the bailing out of insolvent banks that is wrong, not fractional reserve banking in itself. A central bank can bail out banks by loaning them money below market prices (low interest).. this will create inflation. However it is not wrong for a central bank to loan out money at or above market prices (high interest), this is needed sometimes if lots of depositors temporarily demand out their money at the same time (say some 911 thing happens that freaks people out), this would mean that all banks would be short of money, even though they where sound and their borrowers where of high quality. So as long as the central bank lent out money at a high price.. the banks would repay their loans as quick as they could.. that means the money supply would contract back to its previous level.

So in closing fractional reserve banking is a natural thing.. the only way you could make it go away, is to make it illegal.. wich would be a govt regulation of the private free market. I find it abit funny when anti-govt and free market supporters, start going on about how evil banks and fractional reserve banking is. That road leads down nationalization of the whole banking system. That road leads down to more govt, not less. We have to keep the concepts separate. Credit/Deposits is not money. Its lending and borrowing. Banks dont create credit and deposits, people do. The govt has no part in telling people wether they can lend and borrow money from eachother.

Cheers

DriftWood:

So in closing fractional reserve banking is a natural thing.. the only way you could make it go away, is to make it illegal.. wich would be a govt regulation of the private free market.

Thanks for saving me the trouble of explaining it again.

DriftWood:

Fractional reserve banking is a free market invention. It would exist even under pure cold coin system. It has nothing to do with central banks or inflating money supply. If you lend me money, on the promise that you will get back the money on request.. i can do whatever i want with the money in the mean time. I can lend it out or invest it. As long as Invest it profitably as opposed to waste the money. I will be able to give you back your money on request. Fractional reserve banking is lending out short term loans to long term borrowers. It works because many short time lenders, as a whole behave as one long time lender. As long as the bank does not lend out money to people who will not be able to pay back.. the bank is sound and everyone that has lent the bank its money will get back their money.

[...]

Banks can and did issue 'shares' against their assets (i.e. outstanding loans). These shares simply did not function as money under more free market conditions. They always only traded more like stock--based on the risk and inconvenience of redeeming them for specie. Fractional-reserve banking, where a bank issues demand-deposit bank notes against outstanding loans simply doesn't happen under free-market conditions except as fraud. And the markets punished such banks the same way it punishes any fraudulent business.

Fractional-reserve banking only happens on an industrial scale when the government does specific things to force people to use the notes of the politically-favored banks. These things include:

• Grand a politically-favored bank a territorial monopoly on bank note issue;
• Require people to accept the politically-favored bank's notes as legal payment of debt (legal tender laws);
• Require that taxes be paid in the politically-favored bank's notes.

And the most interesting and important way a government can force people to use a politically-favored bank's notes is to make some incredibly important commodity only purchasable with those notes. In the 1970s, the U.S. government made a deal with the House of Saud. The U.S. government would keep them in power. In exchange, Saudi Arabia would only accept U.S. dollars in payment for oil. The rest of OPEC soon followed suit. Now check this out:

http://en.wikipedia.org/wiki/Iran_Oil_Bourse

Now you know the real threat Iran poses.

DriftWood:

 So as long as the central bank lent out money at a high price.. the banks would repay their loans as quick as they could.. that means the money supply would contract back to its previous level.

In practice, under central banking, the money supply always grows over the long term. Governments grant specific banks political privilege in exchange for financing government spending. That has always been the true function of every central bank.

DriftWood:

So in closing fractional reserve banking is a natural thing.. the only way you could make it go away, is to make it illegal.. wich would be a govt regulation of the private free market. I find it abit funny when anti-govt and free market supporters, start going on about how evil banks and fractional reserve banking is. That road leads down nationalization of the whole banking system. That road leads down to more govt, not less. [...]

 

Utter nonsense. Fractional-reserve banking requires massive government intervention. Governments do everything they can to prevent people from circumventing the use of government-sanctioned bank notes. In 1933, the U.S. government flat-out outlawed the use of gold as money. Weimar Germany outlawed posession of foreign currency. As I type, the governments of the U.S. and Canada are setting their sites on increasing regulations on internet 'digital precious metal operators' which allow people to conduct business in units backed by gold and silver rather than paper currencies. They are nominally doing this in the name of fighting terrorism and money laundering of course, but what they really fear is the loss of their power to create money out of thin air.

Fractional reserve banking is a free market invention. It would exist even under pure cold coin system. It has nothing to do with central banks or inflating money supply. If you lend me money, on the promise that you will get back the money on request.. i can do whatever i want with the money in the mean time. I can lend it out or invest it.

hjmaiere:

Fractional-reserve banking only happens on an industrial scale when the government does specific things to force people to use the notes of the politically-favored banks.

Are you claiming that no-one in a free market would choose to take the risks inherent to banking with an FRB bank in exchange for the benefits of it?  Can you support that?

hjmaiere:

Fractional-reserve banking requires massive government intervention.

Where do you get that idea from?  Because FRB has always been done, and at the same time banking itself has always been subject to massive government intervention?  They're two distinct concepts.  The massive government intervention has always been needed to prop up monopoly currencies operating under FRB, because monopoly currencies are not subject to the market disciple that leads to responsible banking. And in turn, currencies are monopolized so that governments can abuse FRB to inflate them and pay for things they couldn't otherwise. 

Take the government intervention out of it, and there's little reason to think that responsible FRB is impossible, and that it wouldn't be chosen by some segment of the market. It's like saying that governments use guns to oppress people, and governments always try to monopolize gun onwership and use, so guns must be bad.  You're mixing up cause and effect.

vp3434:

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!

Since the topic is primarily about fractional reserve banking, for the moment we need to totally clear our minds of any thoughts of central banking.  Fractional reserve banking is the egg that came before the central banking chicken.  So I will postulate a timeframe before central banking or other government interventions came about.

Assuming we already have an established precious metallic currency in general use, for simplicity we will go with gold.  The first money warehouses, <i.e. banks> must of necessity be 100% reserve.  The concept of money warehousing will be new and it will take a few years before people begin to accept warehouse receipts <paper currency> in lieu of the actual gold in the vault.  Over time as familiarity and trust builds the warehouse receipts are accepted as circulating currency in lieu of the actual gold.  EVERY banknote in circulate is backed by actual gold in a money.

At some point, the warehouse manager realizes he can take advantage of the trust people place in the warehouse receipts.  He begins printing and loaning out faux banknotes, unbacked by gold.  People circulate these notes, believing them to be fully backed by gold.

So assume we have 100,000 troy pounds of gold in the warehouse, with 100,000 in warehouse receipts circulating.  In addition, 50,000 in faux unbacked receipts are circulating.  If there is a panic and everybody decides to redeem, you are going to have a shortfall of 50,000 at the bank and many genuine holders of currency will get screwed.

Fractional reserve banking is clearly fraudulent, in that it causes the issuance of unbacked banknotes.  Fraud #1.  Since there are more banknotes chasing the same number of goods and services, it devalues those notes <inflation>.  Fraud #2.

If bankers want to lend money, I suggest they do it the honest way.  Take in timed deposits and loan money based on those timed deposits they hold.  Demand deposits, must be kept on a 100% reserve basis.

histhasthai:

hjmaiere:

Fractional-reserve banking only happens on an industrial scale when the government does specific things to force people to use the notes of the politically-favored banks.

Are you claiming that no-one in a free market would choose to take the risks inherent to banking with an FRB bank in exchange for the benefits of it?  Can you support that?

I'm saying that when banks contractually distinguish between demand deposits and timed deposits, claims on timed deposits do not function as money, and therefore do not facilitate fractional-reserve banking.

I'm saying that consequently, the only way banks practice fractional-reserve banking in a free market is fraudulently, and that markets place an automatic and extreme restriction on the ability of banks to practice fractional-reserve banking without some form of government intervention.

histhasthai:

hjmaiere:

Fractional-reserve banking requires massive government intervention.

Where do you get that idea from?  Because FRB has always been done, and at the same time banking itself has always been subject to massive government intervention?  They're two distinct concepts.  [...]

Fractional-reserve banking has not "always been done." People used to pay banks to store their gold. The receipts for gold were traded in place of the gold. When a bank issued more receipts than it had gold on deposit it was considered fraud, and such banks went quickly out of business. It takes bank-friendly court rulings and massive political privilege for fractional-reserve banking to maintain itself as standard business practice.

histhasthai:

Take the government intervention out of it, and there's little reason to think that responsible FRB is impossible, and that it wouldn't be chosen by some segment of the market. It's like saying that governments use guns to oppress people, and governments always try to monopolize gun onwership and use, so guns must be bad.  You're mixing up cause and effect.

I am not proposing that fractional-reserve banking should be illegal. I have no problem with a bank issuing shares against its investment assets as long as it does so with full disclosure. I'm just saying that such shares won't and didn't function as money. Such shares—absent government intervention—always have and always will trade at a discount based on the risk and inconvenience associated with redeeming them for genuine specie. People can and have borrowed against such shares. I have a book from 1926, "Finance and Investment - Book 1" by Leighton P. Stradley, LL.B., that describes how people can buy shares in and investement and loan, and if they are a member in good standing, they can probably borrow against such shares. But nobody pretended that these shares were redeemable on demand for specie, and no new money is created in this situation. Shares of ownership in bank assets simply did not and would not function as money without government intervention.

Mark B.:

At some point, the warehouse manager realizes he can take advantage of the trust people place in the warehouse receipts.  He begins printing and loaning out faux banknotes, unbacked by gold.  People circulate these notes, believing them to be fully backed by gold.

...

Fractional reserve banking is clearly fraudulent, in that it causes the issuance of unbacked banknotes.

Assume instead that the banker offers this proposal:  Instead of charging you $5 a month to store your money with me, I will pay you to store your money with me.  In exchange, though I will redeem all notes at their full value, they will only be backed by X% of the gold they are a receipt for. This means you will be exposed to the risk that my bank will fail, and you may lose all or part of the gold you have reciepts for.

You may continue to warehouse your money with me at a cost of $5.00 per month, fully backed, or to make non-demand deposits that will bear interest, or you may choose my new fractional reserve plan.

Assuming the banker doesn't cheat on these terms (with "X" being a specific number), is it still fraud?  Do you think he would have no takers? FRB isn't inherently fraudulent, fraud requires lying or deception.

histhasthai:

Mark B.:

At some point, the warehouse manager realizes he can take advantage of the trust people place in the warehouse receipts.  He begins printing and loaning out faux banknotes, unbacked by gold.  People circulate these notes, believing them to be fully backed by gold.

...

Fractional reserve banking is clearly fraudulent, in that it causes the issuance of unbacked banknotes.

Assume instead that the banker offers this proposal:  Instead of charging you $5 a month to store your money with me, I will pay you to store your money with me.  In exchange, though I will redeem all notes at their full value, they will only be backed by X% of the gold they are a receipt for. This means you will be exposed to the risk that my bank will fail, and you may lose all or part of the gold you have reciepts for.

You may continue to warehouse your money with me at a cost of $5.00 per month, fully backed, or to make non-demand deposits that will bear interest, or you may choose my new fractional reserve plan.

Assuming the banker doesn't cheat on these terms (with "X" being a specific number), is it still fraud?  Do you think he would have no takers? FRB isn't inherently fraudulent, fraud requires lying or deception.

A bank should certainly be free to do what you describe, but good luck finding someone to accept their notes as money.