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[With a special thanks to Yaron Brook and some others who got me to change my mind on this topic]

Fractional Reserve Banking

By Thomas M. Miovas, Jr.

06/16/2012

I should point out that I am not an expert on financial issues, so this essay is based upon what I have learned over the years without taking any special courses on banking or banking practices. For the purpose of this essay, I am taking a gold as money standard as the correct system; though other commodities (silver, copper, oil, etc.) can be used as money. My original position, which I have to now change, was that fractional reserve banking was inherently fraudulent because it meant that a bank would print out more Bank Notes than they had gold in reserve. Let’s say they had 100 ounces of gold in reserve (in the vaults) and they print out Bank Notes (BN) as claims against 150 ounces of gold and loan them out or use them as transactions for cash exchanges. Surely, I argued, this means that someone is being defrauded because as those customers come to get their gold from the bank, the bank will come up short by 50 ounces of gold. It would be like writing a bad check and not having enough money in one’s account to cover the check, but writing them out anyhow and taking the products, leaving the producer with irredeemable and worthless paper. However, if I were to write such a bad check and then scramble to make cash deposits that would prevent a default in my bank account against the check, then everything would be OK, and I committed no crime and didn’t defraud anyone.

Fractional reserve banking operates on a similar principle, though a good bank is more careful about writing “bad checks”. Basically, there is a future dynamic to banking that I wasn’t taking into account. A well-run bank will not only be taking in more deposits, it will also be getting returns on loans paid out. So, a sound bank takes its future earnings into account, projecting , everything else being equal, that they can expect, say, a 10% increase in either deposits or payments, and so they can print out an extra 10% in BNs and use it for cash transactions, provided that when the holder of that BN comes into the bank and demands the gold that is backing it up, the bank can hand over the gold from their reserves within a specified period of time to make sure the BN clears (or that they have gold in reserves or can get it to make the transaction sound). There is nothing fraudulent about this, just as you writing a check and making deposits into your account before the check clears is not fraudulent. It is a risky action to take, however, as no one can really predict their future business operations, nor that they will make a profit day over day or year by year.

This is one reason why one would have to be wary of the business practices of one’s bank in a capitalist system, when there would be no banking regulations and no FDIC to back up deposits. If the bank isn’t operating efficiently enough (not getting enough new deposits or enough payments on loans), then it is possible that the holder of the gold BN would be left high and dry when he tries to cash in the BN for gold holdings. It also means that you, the depositor, might not have ready access to your gold cash you deposited until a specified period of clearance is met (say one week to fully close out one’s account). In other words, anyone using the BNs as cash for monetary transactions may be delayed in converting the BN to gold for a certain period of time while the bank scrambles to catch up with the demands on their deposits. For a well-run bank, all of this would be taken into consideration so that their issued BNs would clear for gold at a steady rate; otherwise, no one is going to be using those BNs for cash and would trade in gold only.

So, the dynamic version of banking taken into account and the possibility that one would have a waiting period to get the gold backing the Bank Note issued by the bank means that no fraud or theft is involved, so long as the Notes do clear into gold within the specified delay time, which would be contractual on both the bank and its customers.

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I too have a limited understanding of finance, but my understanding is that fractional reserve lending is wrong mainly because it's a form of inflation. By lending more than a bank actually has, it's increasing the country's money supply.

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I used to think that FRB would lead to inflation as well, but it won't, not if the banks manage their accounts correctly. For one thing, there wouldn't be a national currency in the first place. All issues of money and coinage and minting and Bank Notes would be done by private banks and the government would stay out of it, aside from actual fraud or force. So, the issue comes down to is the bank going to damage it's return on Notes to the extend that the Notes are worth less and less gold over time? Actually, this cannot happen, as a proper BN would state on the face of it that This Bank Note is Worth X Ounces of Gold. So, each Note would be worth a specified amount of gold in ounces and could not be changed after the fact (this would be fraud and would be illegal). If a private bank did declare that a One Ounce Gold Note would only be worth a fraction of an ounce of gold, people wouldn't use those Notes for cash transactions, and the bank would go out of business. Besides, historically, when banks were free to manage their own accounts and many did do FRB, there was less than a 1% inflation rate, and I think that was primarily due to some mismanagement and discoveries of new gold deposits (say the Gold Rush in California, which increased the gold supplies). So, I don't think inflation would be a problem.

But I will have to say that the Founders made a grave mistake in giving Congress the power to coin money and to regulate its value. While the Founders could never have imagined the corruption of the Federal Reserve today, this amendment in the Constitution set the stage for the goldless dollar and the troubles we have today with deficit spending (printing out more dollars to cover government costs). But, they couldn't foresee everything and didn't fully realize that if they didn't spell everything out that Congress would run-amuck and destroy our currency. They also never imagined that a hundred and a few years later, all the gold in the country used as money would be confiscated to make way for the Greenback. They should have left it in the hands of private banks and mints.

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The goldless (inflatable) dollar and deficit spending are unrelated. The government could go into as much debt as it wanted with a completely private currency system, too. Insofar as the Treasury is allowed to sell bonds (denominated in whatever form of money), then into debt we go. The only thing the inflatable currency allows you to do is more easily default on your debt and do so in a granular fashion. But surely the Congress would figure out some other way of doing that if there was no Fed and mints.

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I too have a limited understanding of finance, but my understanding is that fractional reserve lending is wrong mainly because it's a form of inflation. By lending more than a bank actually has, it's increasing the country's money supply.

Let's say I write you a note stating that I will pay 100 dollars to whoever shows up at my doorstep with it (or I create an electronic record that works the same way), and there is someone out there who takes this seriously enough to give you some kind of goods for it. Thus, my note just entered circulation as a currency.

Would you say that my note has therefor become a hundred dollar bill? That now the US economy has another 100 dollars in circulation?

I submit to you that it doesn't. It has the same exact amount of dollars it had before. My notes are not dollars, they are a new form of currency. And there is a crucial difference between me issuing more and more of these notes (that I can't possibly give you dollars for), and me printing a bunch of hundred dollar bills: in the first case, only the value of the notes would decrease, not of the dollar. In the second case, the value of the dollar would decrease.

Fractional reserve lending is not the printing/creation of new dollars (or the creation of more gold, if gold is the currency). It's the printing of these notes I described. The problems start only when the government is in control of both the creation of money and fractional reserve lending, and it fails to sufficiently distinguish between the dollars and the notes. Then, fractional reserve banking does become a tool for monetary inflation (though still not necessarily economic inflation).

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A proper bank monetizes assets. If it uses a 100% commodity reserve, its notes are monetizing those assets by making their exchange convenient. That's the simple case.

Under a fractional reserve system, what is being monetized is the promises of people who borrow from the bank. A home-owner takes a mortgage from the bank. Ultimately, that home stands behind that note, rather than gold. So, the home has been monetized. In another case, a factory might stand behind the note. Banks can also make unsecured loans. So, for instance, in the case of a student loan, what stands behind the note is the promise of the student to pay part of his future earnings to the bank. Each bank note is backed by real assets and real promises.

So, there is a very real sense in which banks create money (or at least a very-near money-substitute) under a fractional-reserve system.

For anyone interested in the British system of the 1800's, I suggest the book Lombard Street, by William Bagehot (one time editor of The Economist). Also, here's a related blog-post.

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Actually, Nicky, in the case of you writing a Note that you are willing to back up with some commodity, you have created a currency, in effect, or you have written a check against your holdings. If you did this and didn't pay it out, then you would be engaged in fraud, just as if you wrote a bad check.

But I do think you have somewhat of a false premises in your posting. Under capitalism, there would not be a National Currency by which one could gauge the inflation / de-inflation scenario. Each bank would be free to issue its own coinage and / or its own Bank Notes (covered by some commodity); and what happens via one bank would not necessarily effect what happens at other banks (depending on their contractual arrangements regarding backing each other up). What would happen is that a particular bank would issue more Notes than they could cover (if mismanaged) and people would do a bank run to get out as much gold (or commodity) they could get from the bank before it collapsed. In those cases, it would be better to get, say, 90% of the face value rather than nothing, but then one could sue the bank for fraud; which would effectively erase all the capital investments of that bank (buildings, teller machines, computers, etc.). The only way real inflation could occur is if people accepted the BNs without eventually exchanging them at that bank for gold, and many more Notes might become into circulation than the bank had gold to back it up -- an increase in the currency (or the Notes used as currency). Effectively, that was how the Greenbacks were able to make headway without causing a violent revolution in America back in 1933. People, for the most part, were no longer carrying around much gold coins, but paper Notes back by gold, and the government convinced them that they could take over and do a better job (and where have we heard *that* one before!). This could not have happened pre-1933 because gold was in circulation as coins.

Edited by Thomas M. Miovas Jr.

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So, there is a very real sense in which banks create money (or at least a very-near money-substitute) under a fractional-reserve system.

While I agree that any asset or promissory Note can be monetized, I wouldn't call this the creation of money, unless you are going to be very careful with the usage of those terms. Making Notes available that has commodities backing it up does make a medium of exchange, but it doesn't create value out of thin air the way the Federal Reserve attempts to do. I don't think that is what you meant, but I wanted to clarify what could be misread by some observers.

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While I agree that any asset or promissory Note can be monetized, I wouldn't call this the creation of money, unless you are going to be very careful with the usage of those terms. Making Notes available that has commodities backing it up does make a medium of exchange, but it doesn't create value out of thin air the way the Federal Reserve attempts to do. I don't think that is what you meant, but I wanted to clarify what could be misread by some observers.
Notes that are claims to commodities are a particular concrete of something more abstract: making notes that are claims to values. Commodities have various features that make them a good basis for money. However, this does not mean that notes based on non-commodity values cannot be money. Edited by softwareNerd

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Right, I agree with that. If done correctly, I guess any value can be monetized. The point is, however, that one has to distinguish creating currency from creating wealth. Creating currency is taking wealth or future wealth and making Notes to divvy it up to use as cash; creating wealth means to take something that is not yet of value (i.e. gooey oil in the ground) and making it into something valuable (gasoline for cars). The problem, as I see it, is that non-commodity money is extremely risky. If the loans made by banks are not backed by collateral, then there isn't anything to back it up aside from a promissory note of future payments. At least with a collateral loan, if the payee defaults, the bank can get the commodity, so they still have something of value to back up their Notes. I think there is a certain sense in which the US government via the Federal Reserve is trying to monetize the debt owed to it by foreign banks and countries, which, as we can observe by the recent actions of Greece, are not worth the paper they are printed on, and will lead to a monetary crises.

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Actually, Nicky, in the case of you writing a Note that you are willing to back up with some commodity, you have created a currency, in effect, or you have written a check against your holdings. If you did this and didn't pay it out, then you would be engaged in fraud, just as if you wrote a bad check.

It's not like writing a bad check. Writing a bad check is fraud because you are paying someone money, the check is simply a stand-in for that money. If you write a bad check, that means you are intentionally misleading the other person in handing you something of value, in exchange for money you are pretending to be giving them, but in fact don't.

Writing a note promising a payout you fail to honor may or may not be fraud depending on your intentions when writing it. If you have every intention of honoring your promise and never mislead the other side on what your promise is backed by, but run into trouble along the way and can't pay up when the time comes, then it's not fraud.

But all this is off the subject. It doesn't really matter if it's fraud or not (incidentally, I never said whether the note was backed by any commodity, because it doesn't matter). The only goal of my example was to illustrate why the mere act of fractional reserve lending doesn't inflate the currency used as the reserve. It does create new money, but only in the form of a new, proprietary currency associated with the lending entity.

Edited by Nicky

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I don't know if this is off-subject, or a troll, or just interesting conversation, but here goes...

My theory is, the traditional notions of economics with respect to monetary policy (e.g. the gold standard et. al.) are anachronisms.

Observe the following "things":

  • The deed to somebody's house
  • A bar of gold
  • US dollar bills
  • British Pound notes
  • Shares of AAPL
  • Shares of FB
  • Some student's promise to pay you back
  • Some company's promise to pay you back
  • Second Life (Linden) dollars
  • Money (denominated in US dollars) in some bank's account

What do all of these have in common? They are all tradeable instruments in open markets 24/7 across the globe. They all change in value relative to each other and everything else a thousand times a second, and their "value" is a contextual *determination* at any given time. They all have risk associated with them, which is baked into their value.

To me, US dollars are just another instrument. The US government is just another counterparty. If the US inflates the dollar I don't feel any differently about it than if Mark Zuckerberg does something stupid and makes the FB stock I'm holding have less value. There is no fundamental difference.

To put it another way, if there was massive inflation of the US dollar, I'd be fine. I wouldn't lose a penny per se unless I made mistakes in my portfolio, but I can make those same mistakes with any other instrument and I do all of the time. The same is true for any savvy investor (and with technology that is fast approaching everybody).

In a fully liquid world, therefore, the only thing you worry about is fraud--and even that can be discounted (to some extent). And no, I don't find the actions of any major central bank truly "fraudulent" when they inflate the currency as it's almost done in the open, and done slowly. Again, this is relatively stable as compared to most other instruments.

Anyhow, when I hear "gold standard", or "inflation", etc. I cringe. To me it feels like an anachronism. I don't care about either of these things and I think technology will make everybody more and more like me in fairly short order.

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To put it another way, if there was massive inflation of the US dollar, I'd be fine. I wouldn't lose a penny per se unless I made mistakes in my portfolio, but I can make those same mistakes with any other instrument and I do all of the time. The same is true for any savvy investor (and with technology that is fast approaching everybody).

In a fully liquid world, therefore, the only thing you worry about is fraud--and even that can be discounted (to some extent). And no, I don't find the actions of any major central bank truly "fraudulent" when they inflate the currency as it's almost done in the open, and done slowly. Again, this is relatively stable as compared to most other instruments.

Anyhow, when I hear "gold standard", or "inflation", etc. I cringe. To me it feels like an anachronism. I don't care about either of these things and I think technology will make everybody more and more like me in fairly short order.

I think the main objection to this argument is that computers/technology can't determine value. Even though in the modern world it is easier to check different values against each other, these values still need to be checked by actual people. People can only check a limited amount of values against each other at any given time, so even with millions of people doing this at once, there will still be many gaps in value assessment. A slow-changing, relatively consistent base with which to judge against all other values traded in an economy is useful for the human mind that can only hold or know so much information (in this case, values relative to each other) at once. He doesn't need to know a hundred value exchanges at once, he only really needs to know one: his good/service offered as judged against that single, consistent value. There will still be discrepancies, but there will be much fewer than if there were no such "base," since everyone will always be checking their offerings against the same base.

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Objectivist Keith Weiner (who is getting his finance PhD I believe) also wrote a piece explaining why FRB is not fraud.

He also describes what he believes is an actual fraud perpetrated by banks: duration mismatch, which is borrowing short to lend long. It is taking money that a depositor would like to put into a time deposit of 1 year and lending it on a 10 year loan. I'm not sure I agree with him that it is fraud, assuming that the practice is clearly stated in the contract signed by all parties, but here is his explanation, in any case:

http://dailycapitali...the-real-story/

Edited by brian0918

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I think the main objection to this argument is that computers/technology can't determine value. [...]

You don't need them to "determine" value, only aggregate them.

Also, by "technology" I mean more advanced banking products. Imagine your plain old checking/savings accounts being connected to a hedge which is a carefully constructed array of instruments which hedge against each other--and is made available to people that don't even know this is going on, only that this is a "safe" way to keep your money (of course there are hundreds of competing products all trying to be "safe").

Yes, I think it's impossible to get past a baseline currency of some sort, and surely "everybody" would pick one to keep score (and value things that they need to sell, make contracts, and so forth). However, if the one everybody picks has problems (viz. they debased your currency), then they'd just switch to another one.

Again, this sort of behavior is actually quite common already in countries where the currency is in trouble. My point is that financial products (driven by technology, allowing experts to aggregate their decisions to the masses) can--and already are--making traditional problems of currency smaller to the point of being insignificant in the broader political problems.

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Yes, I think it's impossible to get past a baseline currency of some sort, and surely "everybody" would pick one to keep score (and value things that they need to sell, make contracts, and so forth). However, if the one everybody picks has problems (viz. they debased your currency), then they'd just switch to another one.

Why aggregate something that hasn't been "determined" yet, or is determined with knowledge/value gaps? The hedge's instruments' values need to be determined, just as with the things on which the instruments are based -- the goods or services. Someone's got to do this determining, and the more convoluted the thing by which other values are measured/determined, the worse -- again, people can only hold so much information at once. How are they to quickly (or at all) determine the value of their good compared to a massive collection of values (banking instruments)?

Not to mention, there is no debasing with a currency like a precious metal.

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To me, US dollars are just another instrument. The US government is just another counterparty. If the US inflates the dollar I don't feel any differently about it than if Mark Zuckerberg does something stupid and makes the FB stock I'm holding have less value. There is no fundamental difference.

Some of the differences:

1. FB stocks aren't forced on anyone.

2. FB stocks aren't backed by the force of taxation.

3. FB shareholders have a say in determining the company's leadership that is proportional to how much stock they own. No one except them has this power.

4. The declared purpose of FB is to generate a profit for its shareholders.

None of these things are true for the dollar.

Edited by Nicky

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I'm not sure I agree [that duration mismatch] is fraud, assuming that the practice is clearly stated in the contract signed by all parties, but here is his explanation, in any case:
Yes, if the facts are clearly stated in a way that reasonable parties would understand them, I don't see how it can be fraud.

The key is that the bank needs to clearly state that the depositors' money is only available on-demand under the assumption that everyone does not ask for it at the same time. With FRB, the reality of the situation is that money is available on demand, as long as certain conditions hold. As long as this warning is clearly stated, I don't see an issue.

The relatively free-banking periods did not see such a warning evolve. So, I assume people simply understood this without being told.

It surprises me that no type of "living will" clauses appeared in the gold-standard fractional reserve era. It is funny to read stories of bank-tellers who are told to count bills out very slowly, and to double and triple count. In today's electronic age, that sort of thing wouldn't work anyway. It makes more sense to me that some type of agreement should be in place that defines a run, and spells out how a bank will deal with a run. I'm intrigued that something like that never evolved.

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I think some of you are forgetting something. While it is possible to monetize just about anything of physical value, the reason gold has stood the test of time is that the overall amount of gold does not fluctuate much across long periods of time and it is divisible in an of itself, and it is durable. Houses, stocks, loans,etc. are not like this. If you took your money based upon FaceBook stock down to your local grocers, he would have to be able to predict the future price / value of FB stock before he could accept your FB Money. Likewise with houses or some other commodity which can be created by man. As for the non-commodities (loans and other values that have to be paid back), the value would fluctuate across time as the number of loans outstanding and the rate of repayment would fluctuate. Gold is perfect for money for all the reasons I stated and these other things are not so good for the opposite reasons. I think one must keep in mind the purpose of a *standard* and the primary purpose of a standard is that it does not change over time -- i.e. even something as big as the Gold Rush days in early California did not significantly change the amount of gold available in the entire world.

As far as using the other instruments as money, when necessary or prudent, I think this did not take hold for the reasons stated above, but also because we have not had freedom of banking for the entire history of the United States. In our Constitution, Congress is given the power to coin money and to regulate its value -- so other options simply were not granted to the banks. Under capitalism, of course, banks would have the freedom to create their own currencies and they could base it on whatever they chose to monetize -- I just foresee trouble with everything aside from a solid standard such as gold.

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But gold has gone up 500% in the last 10 years while nothing else has. It's subject to speculative bubbles just like any other instrument. There's nothing magical about gold.

Gold, by the way, is absolutely "created by man". You understand that you don't find those bars already placed in vaults in bar form all by themselves, right? There's actually a great deal of human action involved in finding, purifying and smelting gold. It's no more "natural" than a box of Certified Organic Wheaties.

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Some of the differences:

1. FB stocks aren't forced on anyone.

2. FB stocks aren't backed by the force of taxation.

3. FB shareholders have a say in determining the company's leadership that is proportional to how much stock they own. No one except them has this power.

4. The declared purpose of FB is to generate a profit for its shareholders.

None of these things are true for the dollar.

1. The US dollar is not forced on by anyone. Please visit your friendly Forex site for details.

2. I don't know what "backed by the force of taxation" is.

3. I'm not sure why that is relevant.

4. Ditto.

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You didn't understand what I said about gold being a non-changing standard because the overall *amount* of gold does not change much over the years. And it has only gone up by 500% when compared to the paper dollar -- or another way of putting it, the paper dollar has lost its value relative to gold because they have printed out so many paper dollars with nothing backing it up. If gold were the currency (trading in terms of ounces of gold as the money), then, no, there would not be speculative binges regarding the value of gold.The value of gold would be in terms of what an ounce of gold could buy, and it is not going to fluctuate by 500% over the years (not unless a whole heck of a lot of gold "gets lost" or gets used for something other than money). You are thinking about the value of gold in terms of paper dollars, and the whole purpose of having gold as money is to wipe out that nomenclature.

http://www.appliedphilosophyonline.com/fractional_reserve_banking_revisited.htm

Real_Money_VS_Crap.jpg

Edited by Thomas M. Miovas Jr.

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But gold has gone up 500% in the last 10 years while nothing else has. It's subject to speculative bubbles just like any other instrument. There's nothing magical about gold.

Gold, by the way, is absolutely "created by man". You understand that you don't find those bars already placed in vaults in bar form all by themselves, right? There's actually a great deal of human action involved in finding, purifying and smelting gold. It's no more "natural" than a box of Certified Organic Wheaties.

There's nothing magical about it, but who said there was? Do you honestly see no fundamental differences between wheaties and gold? Do you plan on making more assertions and then not discussing them?

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For some ideas on why the market has historically picked gold as money, see this chemist:

http://www.npr.org/b...um-einsteinium?

and in general what factors make something money, and why the market still considers gold money, see Keith Weiner's recent lecture (from 6:00 to 12:30):

[media=]

Edited by brian0918

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