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Fractional Reserves

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John McVey
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This really belongs in a separate thread.

I meant one concept for an action and another for its consequence. Such as "issuing fiat money" for the action and "inflation" for the consequence (= rise in P).

Using that terminology you'd be forever qualifying different types of price rises with no one word to work with than 'inflation' while also forever qualifying causes that are or are not inflationary. I'd rather stick with what I have, it's much simpler, clearer (if I presented it all coherently), and powerful.

They can call it whatever they please between themselves if there are no third parties involved.

Strangers would have been a better choice of term than third-party. Strangers coming to a transaction and expecting certain things to hold based on what the wording of the contract is the whole point of what I am saying in regard to the word 'deposit.' When people are not strangers then (epistemological corruption aside) then yes they are technically capable of using words whatever way they please. However, being a bank-customer is on the stranger side, and I'd much rather have clear-cut objectively defined words in contracts and protected as such by the courts.

What do you mean by "unsecured" ?

It's a proper term in finance and financial law. Colloquially, being an unsecured creditor means not having legally-recognised dibs on anything in particular if the business goes belly up. Unsecured creditors are down near the end of the line to get their money back, and are generally only ahead of the various shareholders. Secured creditors are people who do have dibs on specific things (eg an IT supplier might have dibs on the computers, which dibs back their accounts receivable from the IT user, and so on), so when those things get sold the secured creditors get paid first. The reference to law changes is the government's taking a wrecking-ball to this contractually-arranged hierarchy.

Okay, let's say the bank wants 5% per annum for storing a gold coin, and suppose it can earn 10% on its investments. This means that it needs to charge 50% seignorage. Who's going to put his gold coins into a bank for such a price?

My lack of insufficient clarity has us talking at cross purposes...

Say a man has some coins in his pocket, and he walks into a bank. Money-wise, he has two main choices: either he can put those coins into an account, OR, he can instead convert the coins to the bank's notes.

If he puts an ounce of gold into an account, that's $20 credited to it. He will then pay various account-keeping and transaction fees for that. The bank doesn't have to do anything more other than keep track of his details. It's a nice little earner for them just for that alone, just the same way as for specific safety boxes for documents etc, and also as a wider principle as per a number of industries such as lock-up yards and parking garages. The bank does not have to invest a bit of it in order to make a profit, just the same as the parking garage does not need to hire out your car for the day to make money. Further, because the cost of storage is so low compared to the size of the coins, objecting to 5%pa fees is no mere quibble because that much is gigantic! A single coin worth $1000 in today's money isn't going to chalk up anywhere near $50 pa worth of allocated shelf-space and security expenses in a vault. Even adding in admin you'd be lucky if the total reached 0.50%pa for a basic savings account, not 5.00%pa. My transaction fees on share trades are only 0.2% or thereabouts, and that fully covers all admin and legal costs involved in making and keeping all the records of who owns what and who owes what to whom.

If instead he wants a $20 note for his coin, he hands the coin over and gets the note back. BUT, this transaction does not have an account associated with it, so in this case the transaction fee is the seignorage (which it would also be if he brought in raw gold to be minted into coins, which is what the term originally referred to). The person involved need not even enter any branch of that bank ever again. Once the exchange is done, their relationship may well be over and done with. Here, precisely because it is a one-off, the cost can be and has to be a much higher percentage of the coin's value, say 2% or so. To get the $20 note he will have to hand over more than the ounce of gold, say the equivalent of an additional 10 grains of gold. Without fractional reserve banking, the bank puts the coin in the vault (again with very little actual expense for that part), but it gets to keep and invest the extra 10 grains (less admin costs) in whatever way it judges best for its shareholders. It also finds that the use of its note by the customer increases is profile in the market-place, which helps encourage more people to get their notes from that bank, and so even more revenues of 10 grains at a time. Lots and lots of 10 grains at a time adds up to a large amount pretty quickly.

Both of these services also use the front-counter system, which can also be used for a variety of other services. Costs can be kept down through economies of scale, through there being brochures etc available showing the bank's other services, which are also earners for it (eg loans, sales of investments, financial advice, and so on). That in particular is where the advertising-value of the note comes in handy, and why it is not trivial.

you are way overestimating people's aversion to keeping their coins at home, and way underestimating their aversion to the small risk that is associated with fractional-reserve accounts, especially if the former is going to cost them money while the latter is going to yield them money.

You are underestimating the size of the riskiness that would attend a bank pursuing fractional reserves far enough for it to be a potentially worthwhile earner. There would be no deposit insurance, central bank or other bailout mechanism for customers if the bank goes under. If a bank practices FRB then the customers with accounts or holding its notes become dependent on the solvency of the bank to keep themselves solvent in turn, which becomes a particularly nasty vicious circle if that bank has lent to those selfsame customers and so depends upon their solvency for its own. Any notable hint of problems and a run is on. The bank may well be technically solvent, but then the bank suddenly becomes unable to pay its debts when they fall due (this meaning pay up NOW, whenever now happens to be, in the case of retail "at call" accounts) when its reserves immediately on hand run out. The quick sales of assets at knock-down prices to get cash in a hurry to meet those demands then actually endangers that bank's solvency, so more people join the run. The withdrawal of all that cash from those accounts reduces the total money supply because of the credit multiplier being forced into reverse. Less cash circulating then causes total revenues in the entire region to fall, and so contagion spreads because then the assets that ALL banks in the region have backing the accounts are now worth less. In the absence of a central bank, the whole thing spirals out of control because once the run gets started there is NOTHING to stop it until the money supply and hence revenues stabilise somehow - either through all accounts having been emptied and the money supply then just consisting exclusively of the coins or the notes of / cheques from trusted full-reserve banks, or through fractional banks assuaging their customers about their soundness through the shareholders injecting equity plus assets in the form of coins to satisfy the run and so halt the want of withdrawals (which injection then defeats the purpose of running with fractional reserves).

The only real protection that customers have against this is actual legal ownership of the cash in the vaults, which means full reserve plus deposit contracts operating under law of bailment. When FRB remains legally a possibility, it is also in each bank's interest to keep every other bank honest and maintain high reserve ratios. They will accomplish this through regular redemption of notes and cheques to get real gold back from each other when transactions are settled at day's end in the clearing house. If any bank over-extends its notes, ie it practices FRB, the others will pile on to convert the notes they receive back for gold in that clearing house (and in daily banking too if it gets bad). Hence a potent weapon maintaining high reserves, likely 100%, is customers engaging in adverse clearing against the non-100% bank. With all that in place, and not despite but BECAUSE there's no government regulation, such a system is run-proof because the money supply is stable.

And if somebody does decide to store some of his capital in a very safe but completely unproductive form, he will typically want the costs of such storage to be proportional to the amount of time they are stored for. When a bank does safekeeping, it is in the interest of both the bank and the client to make the charges proportional to time.

The storage cost will be trivial compared to the total amount so stored. Again, there is no need for the bank to invest that amount anywhere for it to make a profit.

And, the merits of keeping cash on hand versus investing it somewhere is all taken up by analysis of the demand for money generally. Either a man keeps money on hand (ie in an 'unproductive form') for planned immediate expenditure (eg the fortnight's shopping) and unforeseen immediate expenditure (impulse buys, minor emergencies, etc), or he saves and invests it over whatever time-frame and risk-reward profile suits him. The consideration of time is only in his comparative evaluation of the worth of keeping the money immediately available versus being it tied up in an investment. Whether or not the money at hand is coins, notes, or the content of his cheque account, is of no consequence in this decision, so FRB has no part in it.

There is some risk even if you "invest" your money into a safebox: there may be a big gold rush somewhere in Africa next year, or heavy economic downturn caused by a war, and your very safely kept gold coins might lose 10% of their value. There is no way of storing wealth that is totally risk-free. You weigh the expected returns and the potential downsides of each investment, and choose the one you like best.

That also applies irrespective of the FRB question entirely. If there's a big gold find or downturn then all investments made will go down in value, irrespective of whether the investment is equity, bonds, bills, or the "investment" of cash in a safe or on hand. Again there is nothing here that lends weight to the merits of FRB.

There is nothing about the nature of a fractional-reserve checking account that should necessarily scare a majority of people away from investing a small portion of their wealth that way. Quite on the contrary, it offers them a convenience that I think would motivate them to hold such accounts in a free, gold-standard economy just like it motivates them to hold such accounts now.

I beg to differ, see above. People today tend to be complacent today because they think the government will bail them out. Attitudes will change quicksmart when they realise the government is not going to do that.

What do you mean by "add to the economy" ? The bank adds something to my wallet in doing so, while also making it possible for me to carry a wallet instead of a big bag of gold. That's good enough for me!

Adding to the economy means creating net value and putting it up for trade. Inflation - by my definition, monetary expansion by increase in quantity of fiat media or fiduciary media - does not create net value, it merely shifts it around. Real value in this matter would have to be that the customer chooses to relinquish control of the money for the same time-period or greater of the investment in question. A demand-deposit is the exact denial of that reliquishment because the customer can withdraw anything and everything with no notice. If the account can be cleared without notice then if it's FRB that's a diminution of the money supply also without notice. That's what makes the money supply unstable, and eliminates any possible value attached to the provision of credit on the basis of its origin in FRB.

You're also confusing the issue of where notes come from generally with whether or not there are full reserves backing them. You can get the full benefit of notes without any FRB whatever - and I'd further argue (and history agrees) that the real value of a nominally $20 note from a full-reserve bank is greater than a nominally $20 note from a fractional-reserve bank. When people are free, Gresham's Law works in reverse to see the good money drive out the bad.

Do you really think people like that would form a tiny minority in our hypothetical gold-standard economy? If the proportion of "suckers" is even only 10%, fractional banking would be a major force in that economy, and X would be quite significantly above 1.

Yes, and the economy would be on thin ice because of it, if the rest of the people did nothing to stop it. On the contrary, if other people accepted notes from a fractional-reserve bank they'd do so at a discount from face-value, which in itself would discourage custom with that bank and by default encourage custom with full-reserve banks. These people would then be much more anxious to redeem those notes at the issuing bank for real coins than they would the notes from a full-reserve bank, partly for the riskiness that gave rise to the discount in the first place but also because a profit might be in the offing. The draining of gold from a fractional-reserve bank like that - ie the adverse clearing - would prevent that bank from lending out to any significant time frame, thus hampering that bank's ability to earn, in turn both defeating the purpose of FRB and also scaring away its customer base through lower profitability. That effect, and the threat of it, would instead see that X would not go far away from 1 at all.

JJM

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Colloquially, being an unsecured creditor means not having legally-recognised dibs on anything in particular if the business goes belly up. Unsecured creditors are down near the end of the line to get their money back, and are generally only ahead of the various shareholders. Secured creditors are people who do have dibs on specific things (eg an IT supplier might have dibs on the computers, which dibs back their accounts receivable from the IT user, and so on), so when those things get sold the secured creditors get paid first. The reference to law changes is the government's taking a wrecking-ball to this contractually-arranged hierarchy.

There is nothing to prevent banks from offering (and clients from demanding to be offered) as a collateral the instrument resulting from loaning out the cash--which, if the bank is prudent at all, will be a very secure instrument, and one very well backed with collateral. You may think of a fractional-reserve account as a way for people to invest some of their money in a highly secure and liquid form, but still earn a little interest on it--and you may think of a fractional-reserve note as a transferable mini-account with a constant balance of $1 (or $5, etc...), with the foregoing of the interest being the price of transferability (and the small risk associated with it the price of the better portability in comparison with gold coins).

Say a man has some coins in his pocket, and he walks into a bank. Money-wise, he has two main choices: either he can put those coins into an account, OR, he can instead convert the coins to the bank's notes.

If he puts an ounce of gold into an account, that's $20 credited to it. He will then pay various account-keeping and transaction fees for that. The bank doesn't have to do anything more other than keep track of his details.

This is the first place where you go wrong. The bank is now responsible for the safety of the gold: it has to buy some expensive safes, hire well-trained security guards keeping a watch 24 hours a day, 365 or 366 days a year, 10 years a decade, and take out various types of insurance. The marginal cost of safekeeping an additional ounce of gold may not be high, but opening a new safekeeping site (I refuse to use the word "warehose") is no small expense--and since its 22-carat(*) clients are using that site, the bank will want to charge them for its use, and charge them in proportion to the amount of time their gold spends at the site.

You agree, don't you, that in the case of the account, the bank will be charging the client at regular intervals over the duration of the account, rather than in one big sum when the account is opened? And you also agree, don't you, that a client will likely prefer to pay a smaller sum at regular intervals than one big sum when he opens the account? If he knows in advance exactly how long he wants to keep the account, he may calculate the present value of all his regular payments over that duration and agree to pay it up front, but if he is in any degree in doubt as to whether he will or will not want to close the account sooner rather than later, a periodic payment will carry less risk for him than a lump sum.

It's a nice little earner for them just for that alone, just the same way as for specific safety boxes for documents etc, and also as a wider principle as per a number of industries such as lock-up yards and parking garages. The bank does not have to invest a bit of it in order to make a profit, just the same as the parking garage does not need to hire out your car for the day to make money.

Right, and as you probably know, I have absolutely no disagreement on the feasibility of such accounts, but now suppose that, before walking into this 22-carat bank, our man also considers the option of opening an account with a fractional-reserve bank. The fractional-reserve bank offers him a lower account-keeping fee (or no fee at all) and a periodic crediting of interest to his account, in exchange for having to accept a degree of risk of not being able to withdraw his money in gold immediately--but since his money will be invested into very secure instruments, there is hardly any risk that he will eventually lose even a penny of the total amount he put into the bank.

Now, I am absolutely certain that some people would not be willing to take any such risk and would without hesitation choose the more expensive "100%" account with the 22-carat bank--at the very least, there exist two such people, one named Mr. Rothbard and one Mr. McVey. But your position is that all rational people will inevitably reject the offer of the fractional-reserve bank as totally unacceptable (or at least the great majority of rational people will do so), even though you apparently believe that rational people are otherwise willing to accept risks in life. I have honestly no idea how anyone can come to such a conclusion.

If instead he wants a $20 note for his coin, he hands the coin over and gets the note back. BUT, this transaction does not have an account associated with it, so in this case the transaction fee is the seignorage (which it would also be if he brought in raw gold to be minted into coins, which is what the term originally referred to). The person involved need not even enter any branch of that bank ever again. Once the exchange is done, their relationship may well be over and done with. Here, precisely because it is a one-off, the cost can be and has to be a much higher percentage of the coin's value, say 2% or so. To get the $20 note he will have to hand over more than the ounce of gold, say the equivalent of an additional 10 grains of gold.

Again, suppose that before walking into the 22-carat bank, our man considers a fractional-reserve bank as an alternative way of converting his gold into bills. The fractional-reserve bank offers him to exchange a $20 bill for his ounce of gold, and to exchange the bill back into an ounce of gold, and to exchange the ounce of gold back into a bill, as many times as he pleases, and whenever he pleases, free of charge, with the caveat of there being a slight risk of delay in the paper-to-gold conversion. Again, what you would have to prove in order to support your position is that all rational men will inevitably opt for the more expensive arrangement (or at least that a great majority of them will do so).

Of course, you may argue that the $20 bill from the fractional-reserve bank will be worth less in the market than that from the 22-carat bank, so that, say, your grocery store will charge you $1 for a six-pack of Pepsi if you pay with the 22-carat bank's cash, but $1.01 if you pay with fractional-reserve cash. I doubt that many merchants would bother to make a distinction, but supposing that they would, the question is: what will be greater, the risk premium asked for by the merchants or the seignorage asked for by the banks?

The answer to this question inherently depends on the assessment of the risk involved with fractional reserves, so let's turn to that:

You are underestimating the size of the riskiness that would attend a bank pursuing fractional reserves far enough for it to be a potentially worthwhile earner. There would be no deposit insurance, central bank or other bailout mechanism for customers if the bank goes under.

Let's look at a real-world example of fractional reserves where there is no way of getting bailed out if your reserves fail: the example of automated teller machines. A typical ATM will accept any credit or debit card from any bank around the world, meaning that the total amount of potential withdrawals at any point in time is equal to the sum of the balances of all checking accounts in the world, plus the sum of the credit limits of all credit cards in the world. A 22-carat ATM would have to hold this gigiantic amount of money all the time as a means of ensuring with 100% certainty that it shall never fail. The fractional-reserve ATMs that are actually in existence hold only a tiny fraction of that sum in reserve, and the black-and-white printers they are equipped with are clearly incapable of printing additional dollar bills should they run out of them--so there is no possibility of bailout, no insurance whatever against running out of reserves: if too many people want to withdraw on the same day, the ATM will have no other option but to say "Sorry" to them.

How frequently does that actually happen? I have used ATMs on countless occasions, often withdrawing rather large amounts of money, and I vaguely remember very rarely having to walk away from some of the machines because Windows crashed on them or some similar technical mishap occurred--and there may actually have been a single occasion where I had to find another ATM because the one I first tried did not have enough cash in it. The fact that I have no exact memory of it is testament to the fact that it did not cause any great trauma at all--since I knew that my money was still on my account and I would get it eventually, and that all that happened was a minor delay in my obtaining it, which was an inconvenience, but no unbearable tragedy.

So, on the whole, my experience is that ATMs' rate of failure due to insufficiency of cash is very nearly zero. With the clever use of statistics, banks seem to be very well able to furnish each ATM with enough cash to serve all customers with all the money they want well above 99% of the times. And remember that the ratio of the cash actually kept in an ATM is necessarily a very small fraction of what would need to be kept in it to bring that rate up to exactly 100%. I am confident that banks will also be able to manage their fractional reserves of gold with similar efficiency.

if that bank has lent to those selfsame customers and so depends upon their solvency for its own

If A owes B and B owes A, their debts cancel out, don't they?

Adding to the economy means creating net value and putting it up for trade.

Exactly, and although Messrs. Rothbard and McVey may not consider a fractional-reserve account or bill a value, I do.

A demand-deposit is the exact denial of that reliquishment because the customer can withdraw anything and everything with no notice.

A fractional-reserve demand deposit combines some of the benefits of a reliquishment with some of the benefits of a demand-deposit: You get paid interest, and you still maintain the likelihood of being able to convert your money to gold any time you please. The interest is a price paid for your relinquishing the certainty of being able to do so and settling with a very high likelihood.

---

(*) In case anyone else is reading these lengthy posts, "22 carat" is in reference to my appraisal of John as rather little short of a full-blown gold bug:

Well not a 24 carat one because you don't want to throw me into jail for opening a checking account, but since you apparently don't think I have a right to call it a deposit if I do so, I'll give you at least 22 carat. :thumbsup:

Edited by Capitalism Forever
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While I agree that fractional reserve banking as currently practiced is mainly fraudulent, I don't see why it is harmful for a proper society to have two different monetary institutions: 1.) Money storage warehouses, and 2.) Fractional Reserve Banks. As long as the practices of the FRB are explicity spelled out to the customer before he makes a deposit, no fraudulent activity occurs.

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There is nothing to prevent banks from offering (and clients from demanding to be offered) as a collateral the instrument resulting from loaning out the cash--which, if the bank is prudent at all, will be a very secure instrument, and one very well backed with collateral.

Have you thought about the actual mechanics of what you are suggesting?? That is simply not workable in relation to the practice of FRB. The amount in one person's or business's savings or cheque account regularly goes up and down like a yoyo in massive swings both absolutely and percentage-wise. FRB works on the principle of large numbers, that the bank's entire set of customer accounts as a whole wont normally display those kinds of swings even though the individual accounts it is composed of do. It is in relation to the average levels of that whole sum, not individual accounts, that banks lend out from and hold fractional reserves for. There is no practical way that a bank can offer each individual customer such collateral for those accounts because their contents can drop to zero, or even into overdraft, in a literal millisecond, without notice, then stay there or change again, all without the bank being able to forecast it a jot. How on earth can a bank and a customer negotiate collateral agreements with each other under those conditions?? An account holder in a fractional-reserve bank cannot be anything but an unsecured creditor.

What it would take to make your collateral idea work is for the customer to have some amount from that account that they can't touch for a short while (say a few days or more), equal in value and time-frame to the collateral investment... but doing that converts the situation into the customer forwarding real credit, which the bank then on-forwards as an intermediary to a borrower. There's nothing wrong with that, it's part of what retail banks are supposed to do, and actually do all the time. The point for the moment is that this practice stops it being monetary expansion to the extent of the arrangement's tenor because the amount that the customer now has tied up cannot be used as a medium of exchange (eg no cheques issuable against it), and so their relationship is now totally outside what the concept of FRB refers to.

The marginal cost of safekeeping an additional ounce of gold may not be high, but opening a new safekeeping site is no small expense--and since its 22-carat(*) clients are using that site, the bank will want to charge them for its use, and charge them in proportion to the amount of time their gold spends at the site.

Sorry Cap, that's just bizarre. You're first mentioning exactly why the cost to each customer is trivial, then ignoring it by citing comparative irrelevancies about the cost of the entire operation. The point about a bank as an institution serving many customers is precisely to use economies of scale to spread those big costs over large numbers and so making them small per customer.

You agree, don't you, that in the case of the account, the bank will be charging the client at regular intervals over the duration of the account, rather than in one big sum when the account is opened? And you also agree, don't you, that a client will likely prefer to pay a smaller sum at regular intervals than one big sum when he opens the account? If he knows in advance exactly how long he wants to keep the account, he may calculate the present value of all his regular payments over that duration and agree to pay it up front, but if he is in any degree in doubt as to whether he will or will not want to close the account sooner rather than later, a periodic payment will carry less risk for him than a lump sum.

I don't merely agree, Cap, that is what I said in the first of the two scenarios. Moreover, no, he does not know enough about how much he wants to keep in the account sufficient to make those kinds of calculations. He makes a guesstimate of what to hold as a float, but he doesn't know how much he will actually spend from it or when, making calculation impossible. If OTOH to the extent that he could do those calculations then he wouldn't be keeping it in an account like that but formally investing it to whatever time-frame suits him. All this is the very material dealt with under the concept of the demand for money, which I suggest you look up.

but since his money will be invested into very secure instruments, there is hardly any risk that he will eventually lose even a penny of the total amount he put into the bank.

That's a non-sequitur because there is more to the bank's risk of not paying up than just the impeccability or otherwise of the borrowers it lends to. You are not having an idea of how I can arrive at the conclusion that rational people wont like FRB because you misunderstand the importance of this vital point.

The bulk of the problem is the difference in time-frames between the time in which a customer can withdraw money and the time in which the bank gets money back from the borrower. The banks use the law of large numbers as a juggling act in that time-frame mismatch, which act depends on the average total amount customers have in their accounts not varying greatly. If instead the customers withdraw enough cash to drain the reserves then the juggling act starts falling in a heap and the bank will have to start selling instruments sooner than is normal. To do so quickly enough to meet customer demands for cash NOW means taking discounts on those instruments even if their creditworthiness is utterly beyond reproach because that sell-off depresses the market for them. That is what endangers the bank's solvency and so generates the risk, not just to the individual bank but everyone in the region that this bank's monetary instruments trade in and affect. That is why runs are so frightening, why other banks will generally do their utmost to get gold OUT of FRB-banks ASAP, and why even non-customers will take a dim view of banks practicing FRB.

Again, what you would have to prove in order to support your position is that all rational men will inevitably opt for the more expensive arrangement (or at least that a great majority of them will do so).

I have done so at least twice now.

I doubt that many merchants would bother to make a distinction (between notes from full-reserve and fractional-reserve banks)

They would and historically they DID, including declining notes altogether in preference for coins until legal tender laws came along. I already told you about the ratings agencies and their publications. Institute laissez-faire and this WILL return.

A typical ATM will accept any credit or debit card from any bank around the world, meaning that the total amount of potential withdrawals at any point in time is equal to the sum of the balances of all checking accounts in the world, plus the sum of the credit limits of all credit cards in the world

Which thereby exposes one bank to the reserve practices of all the other banks whose cards it accepts in its ATM's. For account cards, under laissez-faire the banks would institute rules with each other for acceptance of use of ATM's, and so directly keep tabs on each others' reserve practices. For credit cards, the credit-card handling company (eg VISA Corporation) would be the one dictating rules to system members about reserve practices. It would hear complaints from some member banks about other banks' practices and then kick those banks out of the system if they don't shape up.

A 22-carat ATM would have to hold this gigiantic amount of money all the time as a means of ensuring with 100% certainty that it shall never fail. ... if too many people want to withdraw on the same day, the ATM will have no other option but to say "Sorry" to them.

From ATM's, sure, that's what the fine-print is for. However, ATM's are only a convenience and NOT the legally required source from which all withdrawals must be honoured. The bank CANNOT say "hah, sorry" to a customer who fronts up to a teller and asks for their at-call account to be emptied and closed without that dishonour resulting in the customer being entitled to take legal action. The situation of ATM's cannot be analogously extended to retail banking operations in total.

How frequently does that actually happen? ... So, on the whole, my experience is that ATMs' rate of failure due to insufficiency of cash is very nearly zero. With the clever use of statistics, banks seem to be very well able to furnish each ATM with enough cash to serve all customers with all the money they want well above 99% of the times.

As I said, the whole thing rests on a juggling act that can collapse without warning, and that this collapse is presently being staved off by improper government action. Your experience in this (as with everyone else's) is tainted by the presence of central banking, deposit insurance, etc. Under laissez-faire, that remaining 1% can be enough not just to totally wipe out the bank in question but also to cause grief to people who are not even customers of customers of customers of that bank.

If A owes B and B owes A, their debts cancel out, don't they?

NO. Even if the two debts are to the same face value they will likely be at different interest rates, different risk levels, have different covenants and conditions, have different repayments schedules, and most importantly in this topic exist for different time-frames. If the prevailing interest rates or other economic factor were to change, the market values of those two debts can diverge markedly away from previously being the same because of those other differences.

Adding to the economy means creating net value and putting it up for trade.

A key word there is NET. I never said the account or bill would have no value. What I did say was that the nominal worth of the note or cheque account lacking a full reserve is offset entirely by the increased risk and the dilution of the value of all other media of exchange, leaving no net value generated. At best it is merely shifted, but it is not generated.

A fractional-reserve demand deposit combines some of the benefits of a reliquishment with some of the benefits of a demand-deposit:

!?

Relinquishment means the customer cannot use the money so relinquished at all - no cheques, no direct debits, no internet transfers, nichts, nada, zilch, zero. To the extent there is relinquishment there is NOT a demand-deposit, and so the concept of fractional reserve does not apply.

JJM

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While I agree that fractional reserve banking as currently practiced is mainly fraudulent, I don't see why it is harmful for a proper society to have two different monetary institutions: 1.) Money storage warehouses, and 2.) Fractional Reserve Banks.

Fractional reserve banking makes the economy less stable because it makes the money supply dependent on banks' solvency. FRB also dilutes the value of the prior existing media of exchange, creating no new value in total.

As long as the practices of the FRB are explicity spelled out to the customer before he makes a deposit, no fraudulent activity occurs.

Other than a legal quibble over the use of the word deposit, that's fine by me. My point is that being legally fine does not make it acceptable, and I have detailed to Cap the reasons why it is not acceptable.

JJM

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Fractional reserve banking makes the economy less stable because it makes the money supply dependent on banks' solvency. FRB also dilutes the value of the prior existing media of exchange, creating no new value in total.

Other than a legal quibble over the use of the word deposit, that's fine by me. My point is that being legally fine does not make it acceptable, and I have detailed to Cap the reasons why it is not acceptable.

JJM

I think the question becomes, if it is legal, then woudl it exist as a matter of course. I.e. can we think of a reason or investments which would prefer a fractional reserved money supply. I assume by "acceptable" you mean that it would nto exist as a matter of course (bankers would decide it was not in their interest to offer it)? Otherwise, I'm not sure how to take your meaning of "acceptable".

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Other than a legal quibble over the use of the word deposit, that's fine by me. My point is that being legally fine does not make it acceptable, and I have detailed to Cap the reasons why it is not acceptable.

A more proper term would be "investment" probably. And I would second your notion that just because it is legally fine it is not acceptable. I, for one, would likely not accept FRB notes if I was a business owner in the ideal laissez-faire society (unless such said FRB notes were insured by a reputable third party firm, similar to how many municipal or corporate bond issues are insured by MBIA or Ambac today). Nor would I store money with such institutions. But I know that I can invest my money at higher rates of return than any bank would, and I could do the legwork myself. For those who do not wish to do this themselves, and who are content with a low rate of return, an FRB is perfectly reasonable. (Although you may find it difficult to get your notes accepted at many firms).

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It's interesting that this discussion barely touches on the primary role of banks in an economy, that of facilitating the investment of savings into future production, or in agrarian terms, the deferred consumption of grain in the form of seed stock for future harvests.

Deferred consumption (i.e., savings) on a gigantic scale is required to keep industrial production going. Savings pay for machines which enable men to produce in a day an amount of goods they would not be able to produce by hand in a year (if at all). This enables the workers in turn to defer consumption and to save some of their income for their future needs or goals. The hallmark of an industrial society is its members' distance from a hand-to-mouth mode of living; the greater this distance, the greater men's progress.

The major part of this country's stock seed is not the fortunes of the rich (who are a small minority), but the savings of the middle class—i.e., of responsible men who have the ability to grasp the concept "future" and to deposit one dollar (or more) into a bank account. A man of this type saves money for his own future, but the bank invests his money in productive enterprises; thus, the goods he did not consume today, are available to him when he needs them tomorrow—and, in the meantime, these goods serve as fuel for the country's productive process.*

If the bank simply places deposited money in a vault, it is the agrarian equivalent of placing grain in a silo, and then eating it at a later date, rather than planting it to grow more grain.

*You get one guess who wrote the 2nd and 3rd paragraphs of this post

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How on earth can a bank and a customer negotiate collateral agreements with each other under those conditions??

It's enough to negotiate the collateral agreement once, when you open the account. Or do you need to re-negotiate your mortgage every time you make a repayment on the loan?

You're first mentioning exactly why the cost to each customer is trivial, then ignoring it by citing comparative irrelevancies about the cost of the entire operation. The point about a bank as an institution serving many customers is precisely to use economies of scale to spread those big costs over large numbers and so making them small per customer.

If there is less money being stored in the bank, the bank will need less storage space. A larger storage facility tends to be more expensive to purchase, maintain, and guard.

All this is the very material dealt with under the concept of the demand for money

Since you have brought it up: What are the factors influencing the demand for money qua means of exchange? What are the factors influencing the demand for gold qua metal? How do the two interact?

I maintain that it would take an unexpected and exceedingly great increase in the demand for gold, as opposed to what gold can buy, and as opposed to silver or steel or any other metal, and as opposed to diamonds and rubies and any other raw material for jewellery, to precipitate a nationwide rush to the banks to convert transactional balances into the metal gold. You sound like such a nationwide gold-mania is almost an inevitability once people begin to hold some of their transactional funds in fractional-reserve accounts and bills--but I not only doubt that such an enormous surge in the demand for one specific metal is inevitable, I am confident that it is quite unlikely, given that the relative prices of metals have tended to decrease over the decades ever since the Industrial Revolution. (Have you heard of the Simon-Ehrlich bet?)

The bulk of the problem is the difference in time-frames between the time in which a customer can withdraw money and the time in which the bank gets money back from the borrower.

The bank can borrow gold from another bank if its reserves are running low. This is how it works in the current banking system (with Fed balances replacing gold, of course), and there is nothing to prevent it from working under a gold standard. Reserves will be available for borrowing as long as there is no sustained nationwide conversion of transactional balances to gold: If a customer withdraws gold for transactional purposes from bank A, there will soon be gold deposited at bank B, by whoever was the seller in the transaction. Gold reserves at bank A will be running low, but B will have more reserves than its target, so it will be happy to lend A. Then, when a customer of B buys something from a customer of A, the situation will reverse and A will be in a position to repay B, or even to lend some gold to B. As long as the total withdrawals from the banking system do not exceed the total deposits into the banking system, banks will be able to shift gold between themselves as necessary. Only if there is a chronic net withdrawal of gold for non-transactional purposes, i.e. an unexpected surge in demand for gold qua gold, is there a danger that banks across the board might need to sell their assets for gold at a loss--a scenario which, as I have mentioned, people have been betting successfully against.

They would and historically they DID, including declining notes altogether in preference for coins until legal tender laws came along. I already told you about the ratings agencies and their publications. Institute laissez-faire and this WILL return.

Of course there will be scrutiny and auditing of banks' management of their reserves, but precisely this will serve to keep reserve levels high enough for the risk to be negligible. A bank whose bills are not accepted at face value will feel a pressure to manage its reserves more prudently, or else no one will use their bills. It's all about the advertising effect with those bills, as someone whose opinions you hopefully respect is often wont to say.

From ATM's, sure, that's what the fine-print is for. However, ATM's are only a convenience and NOT the legally required source from which all withdrawals must be honoured. The bank CANNOT say "hah, sorry" to a customer who fronts up to a teller and asks for their at-call account to be emptied and closed without that dishonour resulting in the customer being entitled to take legal action.

Whoa, it looks like I underrated you mightily when I only gave you 22 carat! If there were such a thing, this would bring you to at least ... 28!

You are in effect saying that, if a bank has 200 branches and its clients have a total of $10 million in their checking accounts, the bank is obliged to keep $10 million in each branch--a total of $2 billion! And if the same bank wanted to expand to have 1000 branches, it would require an investment of an additional $8 billion in cash to do so! You are in effect saying that, in a rational world, each bank would only have one branch, or at least that people could not expect to withdraw money from any other branch of their bank than the one they deposited it in. I thought Citibank was providing me a great service in allowing me to travel to any country in the world and have on-demand access to my money--but now you tell me that no rational man ought to value such a service, but unconditionally prefer a 100% certainty of being able to withdraw his money from his home branch and nowhere else to an excellent likelihood of being able to withdraw it wherever he may travel!

A key word there is NET. I never said the account or bill would have no value. What I did say was that the nominal worth of the note or cheque account lacking a full reserve is offset entirely by the increased risk and the dilution of the value of all other media of exchange, leaving no net value generated.

I saw the word "net." The point is that the fact that you and Rothbard do not find it a net value does not mean nobody else will.

!?

Relinquishment means the customer cannot use the money so relinquished at all - no cheques, no direct debits, no internet transfers, nichts, nada, zilch, zero.

Yes. Poor customer.

To the extent there is relinquishment there is NOT a demand-deposit

Yes, so why not lessen the extent of the relinquishment in exchange for gaining some extent of availability on demand? Your type of account has 0 risk and 0 yield; at the other end of the scale, a lottery ticket has maximum risk and maximum percentage yield. Some people might prefer the former, some people might prefer the latter, and some people--myself included--prefer something in between: say, an emerging-market stock, or a more conservative stock, or a bond from a reputable corporation, or a certificate of deposit, or a fractional-reserve checking account. And of course, people can combine many of these into a portfolio, holding some of their money in one and holding some of it in another. It doesn't have to be either-or.

It's a bit like renting out your apartment instead of selling it. You don't quite relinquish it, but you do relinquish some of the things you could do with it if you didn't rent it out.

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Whoa, it looks like I underrated you mightily when I only gave you 22 carat! If there were such a thing, this would bring you to at least ... 28!

Okay, now it's not amusing anymore. I'm just going to say we agree to disagree and call it a day. Cheers, Cap.

JJM

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I am jumping in without following this thread in detail. So, with apologies for that, I have a basic question regarding fractional reserve banking. How is it different from insurance? Insurance is similar in a fundamental sense to a "fractional reserve" system. No insurer has enough cash or even assets to pay out all potential claims. Rather, the insurer is depending on the statistical fact that only a fraction of claims will need to be paid out in any given period of time. Recognizing this fact, the insurer safely and responsibly issues policies with a face value that dwarfs the assets he retains to pay claims.

Now, what happens when a catastrophic, once-in-a-hundred years' event such as the Katrina flood creates billions of dollars in claims? How does the insurer plan for such an event and maintain a proper financial reserve, but without having to keep billions of dollars in funds idle for decades? He does this through reinsurance. Reinsurance involves selling the risk and a portion of the premium income to a much wider pool of insurers, in fact, a global pool of insurers. So, when the disaster happens in the U.S., the U.S. insurers can pay claims because reinsurers in Europe and Asia are also paying for some of the claims.

I would contend that this principle can and, in fact, has been applied to banking. But there is one important difference between insurance and banking. The difference is in the nature of the rare, severe claims. The rare, severe insurance claim is driven by statistically predictable, natural events, such as an especially strong hurricane. However, the rare, severe event in banking, a run on the bank, does not have the same constraint that it is a result of physical natural forces, such as weather. Nevertheless, I would contend that this difference is not sufficient to prevent an institution similar to reinsurance from protecting banks from large, sudden draws on their (fractional) reserves.

Banks do this in two ways, by having large scale, and through institutions such as clearinghouses, that function in the same way as reinsurance.

It has been said (by Richard Salsman in his book on central banking, if I recall correctly) that during the Great Depression, whereas the U.S. had 10,000 bank failures (out of a total of 30,000 banks), none of the 5 large national banks in Canada failed. The difference was scale. The U.S. at that time, and throughout our history until very recently, suffered from state laws that severely restricted branch banking. Thus, if a problem such as an economic disaster occurred in one region, it brought the banks down in that region. In opposition to this, in Canada, if a problem happened in Quebec, for example, the strength of the bank's operations across the rest of the Canada would keep the bank afloat.

Clearinghouses were an American innovation to get around the branch banking laws, and they worked quite effectively, if not as effectively as legalized national banking would have worked. Basically, a clearinghouse was an agreement among the member banks that they would lend reserves to each other in emergencies. The clearinghouse served to give its member banks the benefit of scale. The clearinghouse system worked well, if I recall correctly, in the financial panics that preceded the formation of the Federal Reserve Bank in 1913. Incidentally, clearinghouses were outlawed when the Federal Reserve was formed. Observe that the result was a wave of bank failures during the Great Depression that had never been seen before in our country's history.

At the end of the day, free markets would determine which form of banking would emerge. I see no argument whatsoever for making any form of banking illegal. Fractional reserve banking, if fully disclosed to customers, can be offered to them. From the evidence I have seen, I think most banks in a laissez faire economy would be fractional reserve banks for the advantage it gives them in lending out money and keeping costly reserves to a minimum.

By the way, as a final thought, has anyone ever considered what happens when a bank fails? Most of the time depositors would get back a significant portion of their deposits. Their deposits would be paid out first, with other creditors having lower priority. Even a failed bank would have significant assets. A principal consequence of a bank failure is a huge delay in getting your money out, since the bank would have to go through the process of liquidation, but in most cases depositors would get significant portions of their deposits back. So, bank runs and bank failures are not such scary things after all. They would, in all likelihood, occasionally happen in a laissez-faire world, just as other firms and businesses and individuals would go bankrupt from time to time.

I suspect that Murray Rothbard, et al., developed such a fear of fractional reserve banking because their views were shaped by observation of the Great Depression and the shear horror of so many bank failures. However, it must be remembered that those failures were not the result of fractional reserve banking as much as they were the result of the abandonment of gold, the formation of the Federal Reserve Bank, and the laws that restricted branch banking. (These are just the proximate causes of the wave of Depression bank failures. All of the other factors, such as the imposition of tariffs, tax increases, and sundry anti-business policies, that led to the stock market crash and the Great Depression were also causes further removed.)

Edited by Galileo Blogs
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I have a basic question regarding fractional reserve banking. How is it different from insurance?

An insurer making payments on claims does not reduce the money supply when doing so. The deleterious effect on the economy has already taken place in the form of the destruction of wealth that generated the claims.

A fractional bank, by contrast, does reduce the money supply when it pays out on withdrawals. That messes with everyone else's monetary calculations and forecasts even though they might not have any direct connection with the bank, which in its own right causes problems for the economy over and above whatever moved people to make the withdrawals.

Insurance is similar in a fundamental sense to a "fractional reserve" system. ... I would contend that this principle can and, in fact, has been applied to banking. But there is one important difference between insurance and banking. The difference is in the nature of the rare, severe claims.

No, that's just an insurer being a normal financial institution, juggling assets and liabilities as it sees fit. The insurer's portfolio of contingent claims liabilities aren't media of exchange, and so the concepts of fractional reserves and credit multiplication don't apply. If it calculates wrong then its error doesn't make life difficult for anyone other than its shareholders and policyholders, so third parties need not pay all that much attention.

The difference is in the consequences for everyone else's calculations in terms of money. The fractional bank's portfolio of customer accounts and notes payable liabilities are media of exchange, so even non-customers of a fractional bank could be considerably exposed not just to that bank's errors but the errors of the customers of that bank too. Therefore everyone in the region of that bank would indeed pay attention - if there weren't mitigating factors from the government.

It has been said (by Richard Salsman in his book on central banking, if I recall correctly) that during the Great Depression, whereas the U.S. had 10,000 bank failures (out of a total of 30,000 banks), none of the 5 large national banks in Canada failed. The difference was scale.

Not just scale, but of greater confidence in the banks because they had more diverse asset bases. In the US, small banks were shaky because they often had only one or a few asset classes arising from them being small, not just mere scale. So, if those classes got hammered the small banks themselves got hammered. A collapse of one small bank then wiped out part of its depositors accounts, which then crashed out the local money supply accordingly. That crashing out then affects every other business in the region of that bank because there is literally less money able to be spent, which means their own ability to repay debts is endangered. That spread the contagion to other asset classes and other equally small and undiversified banks, and it snowballed from there. Having larger banks allows the bank to halt the snowball early on by temporarily bringing in cash from outside the region, preventing the localised crashing of the money supply - but if the pressure on the assets of one large bank grew big enough then its collapse would be catastrophic for the entire country and probably a seismic event for the whole world.

At the end of the day, free markets would determine which form of banking would emerge. I see no argument whatsoever for making any form of banking illegal. Fractional reserve banking, if fully disclosed to customers, can be offered to them. From the evidence I have seen, I think most banks in a laissez faire economy would be fractional reserve banks for the advantage it gives them in lending out money and keeping costly reserves to a minimum.

I don't dispute the first half of that at all. What I think is that most banks wont do it, even though they would be legally allowed to, because rational customers wont stand for it if they don't have to. For example, large businesses have too much need for avoidance of non-core and unnecessary risks, and have spent enormous sums trying to achieve not just their minimisation but their elimination. The aim there was that they can then reduce uncertainty in their other planning affairs and cut costs by rationalising corporate treasury operations. Without government providing things like bailouts and deposit insurance the risk in having the corporate cheque account held by a fractional-reserve bank would increase, as would many other risks, to the point of motivating a desire to get rid of them.

Also, it's not all just centred on whatever Murray Rothbard has to say. There was an entire fierce debate between two UK schools of thought in the 19th century, between the "Currency School" and the "Banking School." One of the outcomes of that debate was Peel's law, mandating (yes, improperly) full reserves for notes. However, the members of the Currency School did not understand that fractional cheque accounts were also part of the money supply, and the law omitted mandating full reserves for them as well. The result was that the act failed in its mission to prevent inflation and the whole full-reserve argument was brought into disrepute.

JJM

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JJM,

You still haven't addressed (as far as I've seen) the primary function of banks, which is to pool the savings of individuals to fund expansion of production through the lending out of money at interest rates profitable to the bank and to the depositors of the bank.

How do you perform that function effectively without implementing a fractional reserve system?

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You still haven't addressed (as far as I've seen) the primary function of banks, which is to pool the savings of individuals to fund expansion of production through the lending out of money at interest rates profitable to the bank and to the depositors of the bank. How do you perform that function effectively without implementing a fractional reserve system?

One of the bank tellers' job roles is to point out the bank's other products and services to customers. That's what I was referring to with the mention of the economies of scale in teller operations.

Those products and services include the sale of retail-level investments, such as term deposits, CDs, and so on (I'm not getting into the 'deposit' debate again). When the customer buys these either the money comes out of their at-call account. Another alternative is that the customer has an old-fashioned prior-notice account where money can't be withdrawn without giving the bank a certain amount of notice beforehand, and another again being an account with a minimum balance requirement. In whatever way the customer and bank arrange it, the customer has relinquished control of the funds to the bank for the duration. It is that part which makes all the difference in the world, because the concept of fractional reserve applies only to accounts that can be withdrawn from or cheques issued from on demand. There is now no monetary expansion, because instead of the investments so bought becoming vehicles for credit expansion the increase in credit is offset by a matching decrease in account funds usable as media of exchange. The customer has forwarded real credit to the bank, which bank then pools it and on-forwards it to borrowers as you are asking about. This is the same type of scenario I was talking about when I mentioned what it would take for Cap's collateral idea to work.

JJM

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One of the bank tellers' job roles is to point out the bank's other products and services to customers. That's what I was referring to with the mention of the economies of scale in teller operations.

Those products and services include the sale of retail-level investments, such as term deposits, CDs, and so on (I'm not getting into the 'deposit' debate again). When the customer buys these either the money comes out of their at-call account. Another alternative is that the customer has an old-fashioned prior-notice account where money can't be withdrawn without giving the bank a certain amount of notice beforehand, and another again being an account with a minimum balance requirement. In whatever way the customer and bank arrange it, the customer has relinquished control of the funds to the bank for the duration. It is that part which makes all the difference in the world, because the concept of fractional reserve applies only to accounts that can be withdrawn from or cheques issued from on demand. There is now no monetary expansion, because instead of the investments so bought becoming vehicles for credit expansion the increase in credit is offset by a matching decrease in account funds usable as media of exchange. The customer has forwarded real credit to the bank, which bank then pools it and on-forwards it to borrowers as you are asking about. This is the same type of scenario I was talking about when I mentioned what it would take for Cap's collateral idea to work.

JJM

Yeah, I agree that the collateral idea is not workable. Do I get the Johnson's front door and mailbox as collateral for my $200 deposit? The bank should have collateral to back up loans, but that should be transparent to the depositor.

As to the demand account, I don't know how it works in Oz, but here you always get fine print that tells you that your "deposit" will not sit in the bank, that it is insured for $100k, and that it's not actually a demand account.

That's right, in any bank that I've put money into, the fine print says that they reserve the right to enforce a waiting period for withdrawals, I think it's up to 60 days, which gives them enough time to make other arrangements. If they're in cooperation with other banks, that means they can do most transactions (other than straight cash withdrawal for storage in the mattress) with bookkeeping only - no currency required, which makes it pretty easy to deal with an isolated run.

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Yeah, I agree that the collateral idea is not workable. Do I get the Johnson's front door and mailbox as collateral for my $200 deposit?

If you take out a $200 loan on your home, do you need to actually hand over your front door and mailbox to the bank? No, the bank simply gets a $200 lien on your home, which means that if you don't pay, your home will be auctioned off and the bank will get $200 out of the proceeds.

If the bank has gotten some of that $200 out of my deposit account, and for some reason it cannot pay me in cash when I want to withdraw the money, the lien will be auctioned off and I will be paid from out of the proceeds.

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I don't dispute the first half of that at all. What I think is that most banks wont do it, even though they would be legally allowed to, because rational customers wont stand for it if they don't have to.

I would tend to agree with you here. I always sit on the fence as to whether or not FRB should be legal. On one hand, I do see it as a fraudulent practice (come on, you create more banknotes than you have reserves to pay out the banknotes. As a bank owner, your business is bankrupt at all times). On the other hand, I believe that if it is legal and properly disclosed to "depositors" then it will likely cease to exist in a laissez-faire society. So I do agree with you that most banks wouldn't do it, because rational customers would likely not stand for it.

agrippa: The primary function of banks is to make money for the banks' owners and shareholders. Not to help society by lending out money and funding business expansion.

Edited by adrock3215
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Galileo, since I sympathize with your not wanting to read all these long posts, let me just point out that I have already addressed this:

A fractional bank, by contrast, does reduce the money supply when it pays out on withdrawals. That messes with everyone else's monetary calculations and forecasts even though they might not have any direct connection with the bank, which in its own right causes problems for the economy over and above whatever moved people to make the withdrawals.

here (bold added):

I maintain that it would take an unexpected and exceedingly great increase in the demand for gold, as opposed to what gold can buy, and as opposed to silver or steel or any other metal, and as opposed to diamonds and rubies and any other raw material for jewellery, to precipitate a nationwide rush to the banks to convert transactional balances into the metal gold. You sound like such a nationwide gold-mania is almost an inevitability once people begin to hold some of their transactional funds in fractional-reserve accounts and bills--but I not only doubt that such an enormous surge in the demand for one specific metal is inevitable, I am confident that it is quite unlikely, given that the relative prices of metals have tended to decrease over the decades ever since the Industrial Revolution. (Have you heard of the Simon-Ehrlich bet?)

[...]

If a customer withdraws gold for transactional purposes from bank A, there will soon be gold deposited at bank B, by whoever was the seller in the transaction. Gold reserves at bank A will be running low, but B will have more reserves than its target, so it will be happy to lend A. Then, when a customer of B buys something from a customer of A, the situation will reverse and A will be in a position to repay B, or even to lend some gold to B. As long as the total withdrawals from the banking system do not exceed the total deposits into the banking system, banks will be able to shift gold between themselves as necessary. Only if there is a chronic net withdrawal of gold for non-transactional purposes, i.e. an unexpected surge in demand for gold qua gold, is there a danger that banks across the board might need to sell their assets for gold at a loss--a scenario which, as I have mentioned, people have been betting successfully against.

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An interesting discussion.

First, thank you John McVey for the link to the New School economic history website. That is a useful reference to learn more about the historical roots of various economic controversies. Knowledge of history is very important in resolving debates such as this one between fractional and 100% reserve banking.

Along those lines, U.S. banking history is relevant to this debate. Specifically, I believe that the U.S. has more or less always had a fractional reserve banking system. The track record is actually pretty good. Richard Salsman in his book on central banking reviews that history. I have also studied some of it academically myself. During the 19th century, although there were a series of financial panics and recessions, the value of money was remarkably stable. In fact, the purchasing power of money rose throughout the century, with the exceptions of the Wars of 1812 and the Civil War when convertibility into gold was suspended.

Bank runs and failures did occur, but to the extent they occurred at a level that seemed too high, it was attributable to laws that prevented the full manifestation of free banking. In particular, unit-banking laws that restricted branch banking ensured that there were simply too many banks in existence. Of course, that meant that there was also a multiplicity of bank notes in existence, which led to the formation of extensive bank-note monitoring services. These services would publish guides to bank notes that were of poor quality or fraudulent. Although bulky to use because of the large number of banknotes, they still worked rather well. Observe that in Canada with only a few large national banks, there were not nearly as many bank note varieties in circulation. The same would have been true in the United States if national banking had been permitted here, thereby greatly reducing the need for the banknote monitoring services.

After the Civil War, bank notes were still privately issued by banks, but the government stepped in to partially socialize the notes and to introduce an arbitrary and inflexible limit on their quantity. In particular, the government enforced unity of appearance, thereby reducing the branding of the notes and the ability of a bank's reputation to be advertised by the notes. This partial equalization of banks' reputations allowed more notes to be issued by financially shaky banks.

The inflexible and non-market quantity limit on notes that was imposed at the same time was the result of a requirement that banks had to buy U.S. Treasury bonds to "back" the banknotes. The quantity of banknotes they could issue was strictly limited by how many Treasury bonds they held. Of course, when the Federal government produced surpluses and retired its bonds, that had the effect of shrinking the money supply, regardless of customers' demand for money. This inflexibility in note issue contributed mightily to the post-Civil War banking panics.

Having described how government hampered free banks and their note issue, despite such growing interventions during the 19th century, it was a period where money held its value and the banking system was still able to finance (acting as an intermediary) the historically unprecedented explosion of wealth creation by the century's great businessmen.

So, my point in mentioning this is that, in fact, people willingly held fractional reserve notes. This fact has to be reconciled with the assertion made by John McVey that in a laissez-faire world people would not want to hold these notes. The 19th century was not laissez-faire capitalism, but it was so close to it that it is not hard to abstract from the government interventions that did exist and draw broad and true conclusions about how banking would work in a laissez-faire society

I welcome your thoughts.

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This fact has to be reconciled with the assertion made by John McVey that in a laissez-faire world people would not want to hold these notes.

I thought about what I posted above and I am having some second thoughts about it...

A FRB would issue receipts to its depositors that would act as a medium of exchange, i.e. notes. These notes would be redeemable when presented at the FRB for their face value. In exchange for a rate of return which he does not receive at a money warehouse, the depositor assumes the risk that the bank may experience some sort of run and end up unable to pay out the face value of the sum total of all its notes. This is fine as long as the procedures of the bank are spelled out in a consenting contract with the depositor; anything less would constitute fraud on the part of the bank. A possible self-regulating solution to maintain the system would be note-insurers, who would simply play the same role as bond-insurers do in today's economy. An FRB whose notes are insured would enjoy an esteemed reputation for its reserve notes, which would always be guaranteed at face value by the bank primarily, but the note-insurer secondarily in case of the bank's failure. The note-insurer could operate a profitable business insuring the notes of various banks by transferring some risk to resinsurers.

So I suppose it is possible that depositors in a laissez-faire society would utilize FRB's and their accompanying notes. Your lesson from the 19th century is particulary relevant. A depositor would use a FRB because he seeks a rate of return on his gold which he would not receive from simply depositing it at a money warehouse. That is the only reason I can think of. So I suppose the question(s) is/are: Would the rate of return offered by a FRB on its deposits be high enough for a rational individual to accept the risk (non-insured FRB notes)? or: Would the risk be negligible enough for a rational individual to accept a relatively low rate of return (insured FRB notes), which would still be higher than a money warehouse offering no return at all?

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... people willingly held fractional reserve notes.
That's interesting. As you pointed out in another post, a fractional-reserve note is still 100% asset-backed, as long as the bank is well capitalized. In a sense, a fractional-reserve note is like a combination of money+bond, and can serve as a medium of exchange even if it is not pure money.

You mentioned the note-monitoring services. How did people use these services? Did they simply not accept certain notes, or did they accept certain notes only at a discount? If the latter, do you happen to know the ranges of the discounts (leaving out the 10% outliers on either side)?

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agrippa: The primary function of banks is to make money for the banks' owners and shareholders. Not to help society by lending out money and funding business expansion.

Don't confuse motivation with function. The motivation to "make money" consists of paying one entity (depositor) less than what you make from another (borrower). This difference is realized through the size and expertise of the banker, and would otherwise be impossible, or at least much less efficient and much more fraught with risk for investors.

Banks allow investors to spread their risk over a large number of loans; this is value to investors. Banks allow borrowers to get loans with a lower interest rate than would normally be available if they relied directly on one or a few investors; this is value to borrowers. Banks take a small cut of each facilitated loan transaction, and that's how they make money. In the process, they naturally help expand production.

Without fractional reserve banking, the process of investing in future production would be severely curtailed.

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If you take out a $200 loan on your home, do you need to actually hand over your front door and mailbox to the bank? No, the bank simply gets a $200 lien on your home, which means that if you don't pay, your home will be auctioned off and the bank will get $200 out of the proceeds.

If the bank has gotten some of that $200 out of my deposit account, and for some reason it cannot pay me in cash when I want to withdraw the money, the lien will be auctioned off and I will be paid from out of the proceeds.

I don't disagree with you, in the abstract, but you as a depositor do not negotiate the specific collateral involved in your deposit. As I said above, the main value of the bank to the depositor is spreading his investment across all of the loans that the bank makes. The bank buffers you from considering the security of its individual loans by implementing safe lending practices that provide, on average, a high security of loans. If your deposit was tied to a specific loan, you would run the risk of that loan going bad without adequate collateral to auction off (case in point - houses that have lost more value than the down payment), and consequently, you would require a higher interest from the bank to offset that risk. Taking each loan individually, this will result in higher interest paid to depositors (but offset by higher risk and occasional losses); higher int paid by borrowers, with a consequent decrease in borrowing and increase in loan failures; and a lower profit to the bank.

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That's interesting. As you pointed out in another post, a fractional-reserve note is still 100% asset-backed, as long as the bank is well capitalized. In a sense, a fractional-reserve note is like a combination of money+bond, and can serve as a medium of exchange even if it is not pure money.

I have to think about this.

You mentioned the note-monitoring services. How did people use these services? Did they simply not accept certain notes, or did they accept certain notes only at a discount? If the latter, do you happen to know the ranges of the discounts (leaving out the 10% outliers on either side)?

I googled some academic articles on the discounts. They seem to have generally been small (under 5%), and would shoot up in cases where a bank's solvency was being questioned, to as high as 30%. The discounts sound very similar to how bonds are discounted today. Solid, investment grade debt is sold at a small (couple percent) discount to "risk-free" Treasury bonds, but non-investment grade or junk debt can be sold at much greater discounts, 10%, 20% or more.

Apparently, the private money was rated by agencies that were similar to today's Moody's and Standard & Poor's. Good ratings were sought after by the banks. This acted as a check on the over-issuance of notes, which is the typical criticism of fractional reserve banking.

Because this discount information was widely available (anyone could ask about the discount not just by consulting a book, but by going to any bank and asking for the rate of exchange for his notes), members of the public could choose how much risk to assume when they exchanged notes.

In today's world, I would suggest that most banks would have strong, investment grade bond ratings. Just as their bonds are sold at small discounts to Treasury bonds, so would their notes generally be accepted at full face value. A discount would only happen in those rare instances when a bank was having trouble.

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So I suppose it is possible that depositors in a laissez-faire society would utilize FRB's and their accompanying notes. Your lesson from the 19th century is particulary relevant. A depositor would use a FRB because he seeks a rate of return on his gold which he would not receive from simply depositing it at a money warehouse. That is the only reason I can think of. So I suppose the question(s) is/are: Would the rate of return offered by a FRB on its deposits be high enough for a rational individual to accept the risk (non-insured FRB notes)? or: Would the risk be negligible enough for a rational individual to accept a relatively low rate of return (insured FRB notes), which would still be higher than a money warehouse offering no return at all?

People are paid to assume the risk via the discounts. See my just prior posting. By buying a note with a small discount, the buyer is assuming less risk. A larger discount means the assumption of more risk. The beauty of discounting is that it allows *all* of the paper to circulate and perform as money (until there is actual bankruptcy). This is exactly how bonds or even stocks trade today. All financial instruments carry some sort of discount that reflects risk and other factors.

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