Jump to content
Objectivism Online Forum

Fractional Reserves

Rate this topic


John McVey
 Share

Recommended Posts

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.

Yes, definitely. The point is that, as Galileo has apparently beaten me to saying, all your balance is still backed by hard assets.

Link to comment
Share on other sites

  • Replies 77
  • Created
  • Last Reply

Top Posters In This Topic

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.

Of course, and I was thinking about that very issue this morning before even coming to see how this thread developed. I even noted to myself that I should have foreseen it and dealt with it already. Here's my submission on it. I apologise for this being so long, but surely everyone recognises the need for me to set the record straight since I seem to be alone here and people are looking at me in askance.

My basic argument is that there has been fundamental changes in people's knowledge and attitudes: we now know things that we did not know (or properly know) in the past, and what we find acceptable has changed accordingly, both in morality and practicality. There are also new needs that did not exist in the 19th century, and I touched on them briefly in the difference in speed in which ripples from local events spread further and also in the vastly-increased need to take razors to unnecessary costs. Whereas in the past people would accept many things because the bad effects developed slowly and could be dealt with adequately, nowadays colossal amounts of value can be obliterated in a heartbeat. So, given the new knowledge of how many of these risks develop and that the processes that generate them do not have any beneficial sides that make the risks worthwhile, I argue that the rational person would try to minimise and eliminate exposure at the root by shunning the generators of those risks, both directly and indirectly, rather than go to the increasingly difficult trouble of setting up contingency arrangements.

The knowledge

-----------------

We now know - or at least we are now beginning to realise - that there is nothing to be gained by fractional reserve banking. Another, though it is one that only a few today accept, is one I have been raising a number of times (admittedly not in a nice large coherent whole) is that fractional reserve banking is not necessary to handle the volume of credit that needs to be supplied to business. Agrippa asked me for an example of how it could be done without FRB, and I duly complied. My argument (and that of others besides) is that monetary expansion through credit multiplication does not generate new real credit that otherwise would not exist. To put it in terms of the cost of credit, the use of FRB does not - repeat, DOES NOT - lower the real rates of interest. The only change is that FRB takes the credit by stealth from their customers and others, whereas full-reserves would mean that the presently-unwitting suppliers of credit would know exactly what's going on and make their own more informed decisions. Real credit is the diversion of labour and materials that could go into more immediate consumption to the provision of physical resources to permit production for future consumption. Financial credit is the monetary vehicle by which people enact their decision to seek future consumption over present consumption. The only thing that FRB achieves is the obfuscation and rubberisation of that connection between real credit and financial credit, screwing nominal interest rates around as part of that. In the process it generates pointless risks to customers, destabilises the economy both regionally and more widely, and does not even lead to lasting benefits for the banks themselves! As with inflation generally, the only ones who benefit are those who get in on it early, to the detriment of those who get in late, in a game that is less than zero-sum.

In light of that, I submit that the rational person, once coming to understand these facts, wont have a bar of FRB. Morally, they will not seek the unearned, even when it is legally available, and nor will they sanction its provision. Practically, amongst other things the rubbery nature of FRB introduces unnecessary complications in their economic affairs both in person and in business. They will accordingly demand (if they can) that their contracts with their bank for their deposit and cheque accounts specify full reserves and that their holdings be subject to law of bailment rather than credit. They will then make their own decisions about credit provision as they judge fit according to their own selfish criteria. They will also accordingly demand that those they trade with either hand over monetary instruments from a full-reserve account, or they will discount fractional-reserve instruments even more strongly than did people in the 19th century to the point of heavily discouraging others' custom with fractional banks. A major influence in this regard will be medium and large businesses - we have already seen how the likes of Walmart can change entire industries through the demands it makes on suppliers, for instance. I can easily extend that to imagine a big corporation saying that it will refuse to make deposits to suppliers' accounts held in fractional banks, and likewise saying it will only accept payments from customer accounts in full-reserve banks. It would make these demands because it minimises its immediate risks and also its longer term risks because of it being exposed to fractional-reserve banks' activities in the general market regions it trades in: if fractional banking did not exist their forecasts would be much more reliable. Add on just a few more corporations doing that for the same selfish reason and what do you get? Fractional banks would be squeezed out almost entirely, and other people thinking the same thing would deliver the coup-de-grace. Eventually, what few remaining people who might accept FRB there might be would have nowhere else to go, and would never be a large enough market to support a fractional bank. With that, fractional banking disappears.

That is what I hold for the future, but what about the past as Galileo rightly asks? I submit that the cause was in large part just the lack of knowledge of what was really going on. For example, the insufficiency-of-commodity-money argument is fallacious, yet this argument had considerable weight for centuries, and still does today in many quarters. The topic of FRB is a significant contributor that argument as an alleged solution to that non-existent problem. I do not believe that people properly understood that fractional reserve banking contributes nothing, just as they did not fully understand that expanding the money supply generally does not contribute anything. As I already indicated, many did know that monetary expansion in fractional notes was highly questionable and went so far as to pass a law about it, but two points immediately pop up. First, notice again that they did not understand the role played by fractional cheque accounts and demand deposits, and the failure that flowed from this. Second, notice that these people were full-on economic professionals immersed in researching and discussing the matter, yet even they got it wrong, so what chance did the ordinary businessman or retail bank customer have?

And look at us here now!! We are intelligent men perfectly capable of understanding the complexities involved, and armed with the most powerful epistemological system ever devised - yet here we are arguing away. Thus I am content to pin down the 19th century's continued acceptance of FRB on the part of most customers as the product of ignorance via the operation of the division of labour, just in the same way as these self-same businessmen could not be faulted for having bad philosophical theories as bases for their moral thinking. The professional people that ordinary bank customers would rely upon for advice had faulty advice to give - good people knew enough to discount the notes, but that was as far as it went for the vast majority. Whatever else might have motivated acceptance of FRB, I don't know, but I do hold that ignorance is satisfactory as an explanation on its own. The solution for the past in their economic thinking is exactly the same as it was for their philosophical thinking: the right philosophy. We have that right philosophy, we are not so ignorant or at least are becoming less so, and so again I submit that we will increasingly hold FRB to be just plain unacceptable both morally and practically.

The needs

------------

We are in a globalised world, yada yada yada. I shouldn’t have to explain that much to this audience. What I do have to explain is the upshot for FRB today compared to the 19th century.

New communications tools are instrumental in globalisation. The financial world is right there in the thick of it as a major driver of its implementation. It has now long been the case that an event in one part of the world can send financial markets in the opposite corner of the world into a major frenzy within seconds of that event. Even a major financial institution whose bread and butter it is to stay ahead of the competition in dealing with these situations can get left in the dust very easily. So, what chance does a non-financial business have in setting up suitable contingency arrangements if that self-same financial institution it banks with, or those its customers and suppliers bank with, can be sent to the wall without warning? Causes and consequences of that speed and magnitude just did not exist back in the 19th century, even with the telegraph. The difference is comparable to the low speed of shockwave propagation in blackpowder of the 18th and 19th century versus the unbelievably high speed for modern explosives like TNT and RDX. That difference is non-linear in importance as it made possible the triggering of nuclear weapons. In the financial world, nuclear weapons go by names such as derivatives, which did not exist to any noteworthy degree in the 19th century.

In a laissez-faire world the risks to a corporation in holding accounts in a financial institution exposed to things like that shoot through the roof, partly on their own because of globalisation but also because of the destabilisation caused by FRB as indicated above. It is not the business of a non-financial entity to be an expert in dealing with those risks, not even within its finance function. I do not believe that the interest rates receivable on deposit and cheque accounts is sufficient to cover all the costs involved. One of my technical arguments against FRB’s prevalence is that, starting from the small ones and moving on up, many corporations would just say “To hell with it!”, set up their accounts as full-reserve bailment types, save heaps by making a few staff in treasury redundant and selling off / redeploying some of the equipment (see below), and then close the book on the matter. This is the counterpart, the coup-de-grace I mentioned, delivered at the same time as the major corporations making their anti-FRB demands. FRB would be crushed from both ends, large business and small, simultaneously. During the opening phase of introduction of laissez-faire, the interest rates payable to these accounts would rapidly rise so as to try to retain customers, then as the interest rates required get ridiculous suddenly the market for them would cease to exist.

I wrote earlier on to Cap that the interest earnable on transaction accounts plays no role in determining the demand for money. That is mostly right, but I accept that it is still incorrect and so I should fix it. I have even seen advertisements for transaction accounts on the net here in Australia, complete with cute animated graphics. Those advertisements were made for a reason, and apparently ING did quite well out of theirs - but the rate figures in big bold letters also had itty bitty asterisks next to them, and those asterisks referred to terms and conditions such as “minimum balance” or other catches. That’s personal accounts, now about corporate. I know very well that one of the tasks of corporate treasury operations is to keep an eye on the interest rates payable on its deposit and cheque accounts, and direct payments to and from them accordingly: pay out from the lower, pay into the higher, shift money among them when justified, and so on. My point is that this process is not cheap, never mind not free, even leaving aside the transaction fees on transfers. Its practice means having staff who deal with it, them having office space and equipment for their use, and so on. This vigil is called the monitoring costs, and is a component of risk premiums demanded on all investments. Two staff and a couple of computers can easily cost over a hundred thousand dollars per year. In addition, the fact that the accounts they are monitoring are risky in their own right adds another factor that head office has to consider when making its plans - a small one, perhaps, but it’s there nevertheless, and as I have indicated that risk would shoot up in size substantially under laissez-faire. What sort of small or medium sized business can put up with costs of that magnitude when it would be much cheaper to replace the entire lot with just one or two full-reserve accounts and have one staff-member keeping a part-time eye on movements in account-keeping fees?

The larger the business the more that economies of scale can be used, but the costs do still grow and grow. Furthermore, the larger the business the greater the potential for competition, particularly at the medium-large scale. The fierce competition here necessitates the principle of economy of scale being equally applied to having a specialist or even a gang of them out to spend time wielding a razor to any and every cost the business is incurring. In the laissez-faire world, that razor gang is inevitably going to turn its attention to the monitoring costs that have to be paid if bank accounts are fractional and interest-bearing. They will know that benefits have to be greater than risks, that the risks have shot through the roof, that the rational do not seek the unearned, that the immoral is the impractical, and so they will make the slash without hesitation. The result when this is repeated in business after business is the same as before: bye bye FRB.

JJM

Edited by John McVey
Link to comment
Share on other sites

Agrippa asked me for an example of how it could be done without FRB, and I duly complied.

John, here is your answer...

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.

There is a reason that banks offer, as their main product, interest bearing accounts, rather than safe deposit boxes: That is that customers expect banks to invest their deposits in safe, interest bearing ventures. That's why they sign agreements that say in clear terms that they might have to wait 60 days to withdraw funds from the bank. There is not stealth at work, there is no messing with interest rates. It's a service that banks supply to depositors and to borrowers.

If people wanted storage services then the banks would shift their services to safe deposits. They don't. People expect interest, and they are willing to accept a small amount of risk (backed by the gov't if necessary) to get that return on their deposits.

FRB is the way the small investor makes modest interest from his bank account. Sorry, but FRB is not going away, nor do depositors want it to.

Link to comment
Share on other sites

Of course, and I was thinking about that very issue this morning before even coming to see how this thread developed....

I would say this post was pretty convincing. Agrippa replied by stating that depositors would continue to demand FRB because they want interest bearing accounts. This is a bit of Keynesian economics isn't it? Demand creates its own supply? I would say that the typical depositor has no clue how or why he gets interest on his account, and anyone who IS smart enough to investigate into it, will be smart enough to put their money in higher interest-bearing forms, such as CD's, money market funds, stocks, bonds, etc. Again, the questions to think of are the ones contained in my last post. The interest paid on an FRB account would necessarily have to be more than that paid on a money market fund or liquid CD, to entice depositors to take the risk. This is unlikely. At interest rates this high, only a few of the best run banks would be able to invest the deposits at higher rates than they pay the depositors, if any could at all. With interest rates this high on deposits, banks would likely not make money and therefore would likely tend to move toward full-reserve accounts, which they can profit from by simply charging storage fees.

As to the supply-side, I tend to agree with you here John. Firms would want and accept mainly full-reserve notes. It is possible they would accept FRB notes, but at an exteremly large discount, so as to discourage their use. Markets today are globalized as never before. The complex derivatives linking firm to firm via credit-default swaps and the like are staggering. Just look at what happened when the hedge fund Long Term Capital Management leveraged itself up and made a few bad bets in 1997 - it threatened to take nearly the whole financial system down with it due to the extremely complicated positions it had put on. In the end the Fed had to step it, otherwise the various credit swaps and loans which LTCM had with the 60+ banks that dealt with it would have been in serious default. Large firms would not want to accept the risk of holding FRB notes or utilizing FRB accounts. Likewise, the costs imposed on start-up businesses by FRB notes would far outweigh any advantage to use them.

In a laissez-faire world, firms both large and small size would severly discourage the utilization of FRB's. Depositors would seek out interest-bearing accounts, but at rates more conducive to the level of risk than an FRB account. Similarly, FRB notes would only be accepted by the majority of firms at extremely large discounts to their face-value, and no rational customer would continue their use. So I think that you are right John; over time, FRB's would be eliminated from a laissez-faire world, or at the least reduced to a negligible state.

The only way I can conceive of you or I being wrong on this is if note-insurers are added to the mix to insure FRB notes at their face value. Have you thought of the ramifications of such an insurance?

Edited by adrock3215
Link to comment
Share on other sites

John,

I don't understand your answer. Could you summarize it in a few sentences?

My summary of your answer is this:

(1) People in the 19th century mistakenly accepted fractional reserve banking because they were ignorant of its hazards.

(2) In a laissez-faire society, where people are more rational, they would see the problems with fractional reserve banking. Therefore, they would demand full-reserve banking.

You also seem to be making a parallel argument which goes like this:

(1) Fast information flows spanning the globe means that financial problems become global problems very quickly.

(2) Fast information flows make the economy more vulnerable to shocks.

(3) Therefore, fractional reserve banking is more dangerous for today's economy than it was for the economy of the 19th century.

Is this accurate?

GB

Link to comment
Share on other sites

Agrippa replied by stating that depositors would continue to demand FRB because they want interest bearing accounts. This is a bit of Keynesian economics isn't it? Demand creates its own supply?

Yes, demand creates supply.

Demand for a thing that exists raises its price, making that thing more profitable to produce than it was before, which increases the relative incentive to produce it, and thus its supply. This is not Keynesian, because it relates to a single product in a larger economy, while Keynesianism propones raising aggregate supply (i.e., production) by increasing aggregate demand (i.e., money).

I would say that the typical depositor has no clue how or why he gets interest on his account

A statement of this type expresses a lack of respect for the intelligence of man. This is a bit of socialist economics, isn't it? :thumbsup: This line of reasoning will get you nowhere but a centrally planned economy in which we can help the poor individgle figger out the best way to spend/invest his money.

... and anyone who IS smart enough to investigate into it, will be smart enough to put their money in higher interest-bearing forms, such as CD's, money market funds, stocks, bonds, etc.

Unless he understands and values the prospect of being able to access his money when he needs it, and unless he understands and trusts the bank's ability to minimize risk by screening and pooling loan applicants. CD's require a term of deposit, which savings accounts don't. That term incurs an indefinite amount of risk that you will not be able to access your money when you need it, so you are paid a slightly higher interest rate to offset that risk. The bank is willing to pay that interest because it gains value from knowing how long it can count on having that money around. The penalty for early withdrawal is calculated to offset the additional risk that a person will come early for that money. As for money market funds, stocks, and bonds (etc.) the higher ROI is required because those investments incur even higher risk than savings and CD's.

Again, the questions to think of are the ones contained in my last post. The interest paid on an FRB account would necessarily have to be more than that paid on a money market fund or liquid CD, to entice depositors to take the risk. This is unlikely.

Again, the service the bank provides is minimizing risk by screening loan applicants, demanding collateral for loans, and spreading the risk across a large number of screened loan applicants. Higher risk applicants pay a higher interest and are required to put a higher percentage of their collateral's worth to offset the additional risk. The result is a very low risk on aggregate loans, and thus savings accounts, all things accounted, and therefore a lower interest rate required to draw investors. The argument seems to be that savings accounts survive by dint of mass ignorance on the part of the "typical investor," which I reject.

Link to comment
Share on other sites

I had some more thought and I realised that what I had written is still incomplete, particularly in the needs section (eg interest and the demand for money bit). If anyone asks about those issues then I will deal with them, but without that I am not going to belabour the point.

I don't understand your answer. Could you summarize it in a few sentences?

Knowledge:

FRB does not see the provision of credit that would not otherwise exist; corollary is that it does not lower real interest rates. This is same principle as monetary expansion generally.

FRB blurs and rubberises the connection between financial and real credit, which amongst other things destabilises the economy through ephemeralising part of the money supply and making forecasts less reliable. This directly affects individual businesses; big ones will use their influence to try to undo this for their own selfish needs.

Banks' expansion of credit through FRB is almost the theft of credit, actually was when this all started. Banks today don't even benefit from it, unless they expand credit further and lower their ratios. The moral man wont turn a blind eye to that, nor to FRB's tainted origins, even if he can get a few % on his accounts. He will also recognise that his sanction by gaining those % contributes to the pointless generation of more risks to everyone else and not just himself: he will recognise a negative-sum-game when he sees one. This will underscore, and likely precede, big businesses using their influence to favour full-reserve accounts.

19th century businessmen were only partly aware of the above - not ignorant of its hazards so much as ignorant of how far the issue actually went. I'm sure the Currency School advocates would have included accounts in their law if those advocates had realised their connection to causes of inflation.

Needs:

Globalisation sees risks increase in speed and magnitude, to the point of causing a non-linear shift in attitudes. These have already increased monitoring costs, and if laissez-faire is implemented then the risks of bank failure and subsequent required monitoring costs will skyrocket further still. The increasing difficulty and cost of managing such risks will grow so much that, starting from the small ones on up, businesses will just give up trying and switch to full-reserve accounts instead. Combined with the above, FRB will be squeezed hard from both ends of the size spectrum.

19th century businessmen did not face the need to cut costs anywhere near as hard as is felt today. It was certainly there, but it was uncommon enough to be noteworthy when someone, such as Rockefeller, made an issue out of it. Nor was there the prevalence of the economies of scale that permit the putting together of razor gangs as exist today. Those gangs will look at the rising monitoring costs compared to the few % gained on the corporate cheque accounts. Again, morality will precede and underscore this.

My summary of your answer is this:

Your first one is mostly there, and my response above should fill the gaps.

You also seem to be making a parallel argument which goes like this:

(1) Fast information flows spanning the globe means that financial problems become global problems very quickly.

(2) Fast information flows make the economy more vulnerable to shocks.

(3) Therefore, fractional reserve banking is more dangerous for today's economy than it was for the economy of the 19th century.

Is this accurate?

Not quite. 1 and 2 are correct, but while 3 is a valid conclusion it is not the final conclusion I'm drawing for what motivates businesses to shift their preferences. Your summary is making it look like I'm saying businesses will see "aha, tragedy of the commons" or similar argument about the financial sector and the entire economy as wholes. My actual argument is that businesses will look at the risks they face directly because of their own financial institution, plus those of their customers and suppliers, being hideously unstable in the face of globalisation while practicing FRB in a laissez-faire world. In response to that they will then selfishly say, "no, it's not worth the trouble."

JJM

Link to comment
Share on other sites

I think there's a misunderstanding of the conceptual basis of fractional reserve banking, and possibly, a confusion of this concept with the fractional gold standard.

A fractional gold standard places a gold value on currency, and proceeds to print more currency than can be backed by the reserved gold, in the hopes that no more than that fraction of currency will be presented for gold at any one time. I think we will all agree that a fractional gold standard is a fraud perpetrated on hapless individuals by a corrupt government (or bank).

Fractional reserve banking, on the other hand, is actually conceptually very similar to a proper gold standard.

No one here, I hazard to guess, would object to a bank taking your deposit, purchasing an equivalent amount of gold with it, and storing that gold in the vault. But that is conceptually what a bank does, except that instead of gold, it holds titles or liens against properties, the total value of which is at least as great as the total amount of money deposited in the bank.

Getting the similarity with full gold standard requires you to look at it from the point of view of the borrower, not the depositor. From the borrower's point of view, he deposits the title to a piece of property he owns in the bank in return for cash. This is conceptually the same as relinquishing the property itself, except that the bank has no right to dispose of the property, as it does not, properly "own," but merely controls it, subject to the terms of the loan. It is essentially the same as a person bringing gold to the bank and receiving money in return, except that the loan specifies an agreement to pay back the value of the loan, along with interest, until the full value has been paid and the property (the right to dispose of it, that is) is returned to the borrower.

The depositor, on the other hand, as the originating source of the money paid to the borrower, receives a share of the interest. But, because the bank is the agent between him and the many borrowers, he does not have to incur the risk of any one loan, and, because the bank retains a fraction of the total amount of money in the bank, which fraction is usually more than enough to handle all transactions of given time period, the depositor can usually count on having access to as much of his money as he needs from day to day. The value of this arrangement to all participants would be undeniable if it weren't for the fact that apparently some people do deny it.

Link to comment
Share on other sites

I would say that the typical depositor has no clue how or why he gets interest on his account

That's a bit unjustly harsh, there, man. It's just the fact that it is not the responsibility of depositors to investigate the depths of economic theory when choosing whom to bank with. That's what economists and other professionals are supposed to do, and to date they've not done a bang-up job of it.

So I think that you are right John; over time, FRB's would be eliminated from a laissez-faire world, or at the least reduced to a negligible state.

Practicality alone would drive it down to a negligible level, though I don't think it would necessarily complete the job. It is the moral component that would make the difference between negligible and non-existent.

Have you thought of the ramifications of such an insurance?

Yes, as did Galileo in reference to reinsurance. Again, from the practical perspective, this would just lower the net interest gained further still. Since FRB is a negative sum game, an insurer that did its sums properly would end up levying premiums that were above the interest gained, eliminating any market for it as might be formed at the start of laissez-faire. I don't think any cluey insurer would offer that kind of cover in the first place, because of that.

JJM

Edited by John McVey
Link to comment
Share on other sites

No one here, I hazard to guess, would object to a bank taking your deposit, purchasing an equivalent amount of gold with it, and storing that gold in the vault. But that is conceptually what a bank does, except that instead of gold, it holds titles or liens against properties, the total value of which is at least as great as the total amount of money deposited in the bank.

That much as it stands is fine, but I believe you're missing the point about what FRB actually refers to. When a customer deposits money into a cheque account and the bank then lends some of that out, the customer is still able to use the entire amount as money even though some of the real money deposited was lent out again. In that way the total money supply is increased. This generates inflation right there, but it also makes part of the money supply dependent on what people do and how good the bank is at a juggling act. If the bank gets that act wrong then there will be a deflation because the customer will withdraw money. Money has been created out of thin air, and can easily go back to where it came from. In this way there is introduced a measure of instability that is not offset by any real benefits elsewhere.

The ordinary customer, not versed in economic theory, misses this because it is too remote from the directly obvious. He sees the extra interest he is getting, but does not see the deeper instability he is contributing to by having a fractional account. If he did he would think twice about the true value of that interest he's getting. One of my arguments is that as more people do begin to see that deeper part then they will indeed think twice.

This is conceptually the same as relinquishing the property itself, except that the bank has no right to dispose of the property, as it does not, properly "own," but merely controls it, subject to the terms of the loan.

There's the rub right there. First, there is no real relinquishment - the customer can still issue cheques or do internet banking etc from that account as though nothing fundamental had changed. The money gets doubled up to the extent that some of it is loaned out again, and that's how the money supply is expanded.

Second, under the current law the bank does indeed own the money and the customer does not. That is what I was referring to in the discussion of the meaning of deposit, the customer as unsecured creditor, and the difference between law of credit and law of bailment. Under the current set-up, which uses the law of credit, when a customer deposits money the bank then takes legal ownership of it, though has an accounts-payable liability of equal size generated in the process. At the same time, the customer ceases to own that money, and instead comes into ownership of an accounts-receivable asset - but as in the first point above this includes ability to make payments using it, which as I have argued confuses the issue for most people of who really owns what.

The value of this arrangement to all participants would be undeniable if it weren't for the fact that apparently some people do deny it.

You're missing the greater and more subtle disvalue generated in the process. Hazlitt's One Lesson is to be sure to look for those deeper consequences and not just to focus on the immediately apparent.

JJM

Link to comment
Share on other sites

That much as it stands is fine, but I believe you're missing the point about what FRB actually refers to. When a customer deposits money into a cheque account and the bank then lends some of that out, the customer is still able to use the entire amount as money even though some of the real money deposited was lent out again. In that way the total money supply is increased.

Okay, let's take this down to the concrete and see where one of us is bollixed.

Given: a banker, a depositor and a borrower.

Depositor deposits $100 in bank.

Borrower comes in, looking to borrow money for a new widget maker.

Banker looks at borrower's credit rating, looks up the value and resale value of the widget maker, and determines that the resale value of the widget maker is $100, the cost new is $110, so he stipulates to the borrower that he must put down $20 of his own money to secure a $90 loan for the widget maker. He further stipulates that the bank will hold the title for the widget maker and that the borrower must maintain insurance against loss or damage to the widget maker.

Borrower accepts, and the loan is made.

Borrower purchases widget maker with depositor's (ok, now bank's) $90, and proceeds to make widgets.

Depositor, who would otherwise have put his money in a safe deposit box, effectively taking it out of the economy, thus deflating the money supply; now has his money working for someone else, bringing the money supply back up to where it would have been without savings.

As long as depositor doesn't need to withdraw any more than $10, all is well.

So in the steady state, FRB could be said to be inflating the money supply, but in fact what it really does is keep the money supply from being artificially deflated through removal of money from the economy. There is no money being created out of thin air, just money being kept out of thick safes.

Okay, so given the hypothetical, if depositor gets hit by a truck and needs $100 for medical care, there's a problem. He goes to the banker demanding his money. Banker has nothing to give him except the title to the widget maker, and is unwilling to give that up. The only thing to do is for the banker to "transfer" "funds" from the depositor's account to the doctor's account to pay for the medical care. Okay, now there's a problem, because now there's a facility by which value can be transfered from one person to another without the use of money. Direct transfers provide precisely the same function as currency transfers, so the transfers effectively increase the amount of money in the economy by an amount up to the total amount loaned out. Theoretically, it could approach a doubling of the money supply.

Aaahhh... okay...

But, so what? FRB doesn't lead to a continuous expansion of the money supply, only to a maximum of double the amount of currency. That means it's not, properly, "inflation," which implies continuous growth. The effect on the economy is that under growth conditions, the money supply will increase because people are earning enough to save, and businesses are profitable enough to attract new entrepreneurs to take loans on those savings. As the economy contracts the opposite happens and the effective supply of money decreases, as it should. So money supply grows with increasing production and shrinks with decreasing production... Aside from the delay involved and consequential overshoots, this would tend to keep price levels steady.

I'm still not sure I see a huge problem here. The two downsides to FRB, unsecured credit and effective expansion (not inflation) of the money supply through bookkeeping transactions, are mutually opposing functions and their combined effect is limited. As long as the base money supply does not continually inflate, there should be no problem.

What am I missing?

Edited by agrippa1
Link to comment
Share on other sites

What am I missing?

You need to look up how FRB actually works to generate a "credit multiplier". It can rise to much much more than a doubling. Mathematically, that multiplier is the inverse of the reserve ratio. For instance, 20% reserves means the money gets multiplied by (1 / 0.20) = 5 times. In this case, the $100 put in by the original depositor will turn into $500 in people's accounts, counterbalanced by the $100 sitting in the bank's vaults and tills plus $400 worth of loans. One of the troubles of this is that just as $100 turns into $500 when deposited, $500 turns back into just $100 again when withdrawn in cash. People in business etc start getting used to the $500, set up all their prices and valuations according to it, but then all those plans are shot to pieces if someone wants to withdraw cash. Just as there were created $400 in new loans, those loans now have to be liquidated.

Sounds really nasty, doesn't it? In reality it is nowhere near as bad as that. The trick to keeping it up is that even though different people may withdraw cash other people are also depositing cash at the same time. FRB depends on the principle of large numbers. Even though any one individual can make their personal account go up and down like a yoyo, the aggregate of heaps of people doing this works out to be nice and smooth for the vast majority of the time. At the same time as that is happening, old loans are maturing and new loans are being made, so there doesn't have to be emergency liquidations either. There is of course still that chance that more people than usual can make deposits or withdrawals, but in most cases that is just a 'blip' and it is part of the bankers' trade to deal with that in an intelligent manner. This is the juggling act I was talking about.

But, even so, there is still the chance of a major event that is beyond a bankers' ability to deal with. If it does then a run can be triggered, and if things get out of hand it can send the entire economy into a nosedive because of everyone having gotten use to the high level of money circulating around that is then crashed out when banks fail. This means there is always that instability lurking in the background, ready to strike without warning - and the lower the reserve ratio the closer to the foreground it is and the nastier its effects can be. Nothing comes without cost, and the cost of having all those loans plus the ease of using cheque books etc is that background risk. Banks pay some of the interest they earn on the loans to the people with the accounts. Theoretically, that may mean the benefits outweigh the costs, right? This is what everyone else here has been arguing in favour of. Their basic argument is that we are, or should make ourselves, informed of the risks, we can get better and better at managing risks using an array of complicated risk management tools such as insurance and reinsurance, and gain interest plus benefit from more lending to business. Some times we win some, some times we lose some, but averaged out over time it's a positive-sum outcome, right?

Wrong! One of the key elements in the positive-sum theory is that there is supposed to be more lending to business than there would otherwise be. That's what's supposed to pay for the interest earned on the accounts, making the risks worthwhile. The trouble is that this idea is in fact false. It is in the physical realities of what credit and interest are about that this really hits home. There are only so much physical resources and potential labour that can be used to produce with. The real interest rate is a reflection of people's priorities on whether to direct the labour and resources to producing consumer goods versus producing producer goods. Playing about with fractional reserves does not alter people's priorities in favour of more production! When the dust settles there in fact wont be more real value lent to business than without FRB. In the financial numbers, the only thing that happens is the taking away of capital from some and redistributing it, through the financial sector, into others' hands. This means that, at the best, FRB is only a zero-sum game.

In the old days this redistribution was actually theft, and the guilty parties should have been prosecuted for it. If they had been, and if the courts at the time had bloody well done their jobs right, we would not be in the mess we're in today. Nowadays since people are aware of the principle, it is questionable but not necessarily criminal in any particular instance. The interest gained is still the receipt of the effectively unearned and the moral man will shun it as such, but it is no longer theft because everyone is or can be perfectly aware of the whole set-up. There are those who whine about global banking conspiracies, usually citing idiotic crap about Jews' plans to take over the world, but in truth hardly anyone at all today can be held as actually guilty. All the guilty parties are long dead - at least in industry, for in academia there are those who know damn fine something is fishy but keep on advocating FRB for dishonest motives (but that doesn't mean that any and every academic who does advocate it is dishonest, mind.)

Can we say, then, that FRB is a zero-sum game and since nobody but a few academics like Keynes are guilty, we have no grounds for automatically making it illegal, we should just let it be, and carry on business as what now constitutes usual, right? Nope! FRB is not even zero-sum. Here, that instability comes back to bite us. The fact that the instability exists causes a number of problems. That instability makes forecasts into the future much less reliable than they otherwise would be. This occasions people to incorporate higher risk premiums into their hurdle-rates for investments. That means investments are less likely, so the total amount of credit provided to business is in fact less than it would be without FRB. The difficulty of making forecasts will then lead big businesses to use their influence to squelch FRB as much as they can. The presence of that instability also occasions people to spend time keeping a watchful eye on the financial sector, incurring transaction costs when shifting cash from account to account, and ever vigilant to step in and try to salvage what one can if things look like they're going sour. Keeping that up is not free. It costs time and money to do: these are called the monitoring costs. It is a distraction from concentrating on core business activities, which small businesses are in no position to do with any real effectiveness and which as business grows larger ends up meaning the expense of hiring special staff and providing them with resources to keep up with it all. In sum, investment is reduced and costs are increased, and in the finish up we bear the burden of that in the form of a lower standard of living. Therefore, fractional-reserve banking is a negative-sum-game. It makes us all WORSE off.

So why did it exist in the 19th century and why the hell does it still exist today!? In large part, plain ignorance - in morality, ignorance of the fact that the interest gained is actually the unearned, and in practicality, ignorance of the fact that the interest is more than counterbalanced by the non-receipt of other benefits and also the generation of other costs elsewhere. It is a question of the seen versus the unseen, of failing to heed Hazlitt's One Lesson. We don't benefit, but what about the banks themselves? A given individual bank gets no benefit from FRB when the reserve ratios are stable. Competition sees to it that in the net return on capital employed in their retail operations is just the same with FRB as it would be without it. The only way a bank can benefit is if it lowers its ratio further and sooner than its competition. In that way, it earns extra income on the more credit - but in due time the other banks do likewise and so the extra profits earned by the first bank dry up. If you're interested, since I'm making all this mention of game-theory, note that all this can be couched in terms of a variant of The Prisoner's Dilemma with some bells and whistles tacked on, but it isn't necessary for understanding of what's going on.

It was the government's failure to stop FRB at its outset that started that downward spiral. They've since called a halt, more or less, but not to undo FRB. Instead, nowadays the central banks and other regulatory agencies directly or indirectly set minimum reserve ratios and other related criteria. So, the degree of FRB today is pretty much fixed. No bank can benefit by pushing it further because they're not allowed - but nor is there any benefit to reversing the direction under the present set-up because the first to do so will be less profitable, unless it can gain more custom by advertising its lower riskiness. The problem is that the promise of bail-outs and deposit insurance etc stop that from being an effective advertising point, because the government's interference means customers see no benefit to them from the lower risk and only the reduced returns. That would change when laissez-faire is reintroduced. Since now we know better, or are coming to know better, we'd even demand that banks do that ahead of them trying it off their own bat. In law we'd even fix up all the mistakes made over the past centuries. Under laissez-faire, FRB would be consigned to the dustbin of history.

*blink*blink* I should have written my argument like that in the first place.

JJM

Edited by John McVey
Link to comment
Share on other sites

John,

I have discovered a new fallacy of argument in reading your posts. I would call it the "Fallacy of Streaming Arguments." With all due respect, you throw out so many floating ideas that it is impossible to engage them. I will make just two points in response.

First, I find your dismissal of the record of 19th century banking unconvincing. Your key argument is basically that people were ignorant. Therefore, although millions of economic actors, both businesses and individuals, found it in their self-interest to participate in a system of gold-based fractional reserve banking, their decisions taken as a whole were motivated by ignorance. Once that ignorance is lifted by the injection of rational philosophy, in a pure, laissez-faire world people will reject fractional reserve banking.

In form, your argument reminds of the argument for the "New Soviet Man," the perfect, selfless man who will emerge once true communism is achieved.

Reason was not invented by Objectivism, although it was properly validated by it. Men in the 19th century were certainly capable of acting in their rational and well-informed self-interest. They usually did so. Proof was the result that the 19th century was the most productive century of human progress up to that point in human history. I cannot look at the achievements in railroads, steel, electricity, etc., and then say that the achievements in finance and banking were based on mass ignorance.

Second, I believe you are obfuscating the alleged problems of fractional reserve banking with actual problems caused by central banking and other government interventions. Artificial stimulations and contractions of money caused by a Fed whose policies are unmoored by gold are the principal cause of every financial panic and the ensuing recessions and inflations we have suffered. That was even true in the 19th century because even then government intervened in banking, although not nearly at the scale we see today.

Other interventions that have undercut the stability of our financial system include deposit insurance and Fed-sponsored bailouts of large financial institutions under the "too big to fail" premise. These two factors socialize risk-taking so that individual financial institutions feel emboldened to take excessively risky actions. The institutions know that there is a partial "put" on their actions because the Fed will bail them out if things degenerate too far. We see this today with the massive liquidity injections into major banks such as Citibank and the Fed's decision to assume (i.e., socialize) $30 billion of Bear Stearns debt.

Moreover, the nature of our mixed economy itself leads to financial instability. In a mixed economy, no rule is fixed, every law is subject to change. All sectors of our economy, including banks, are buffeted by a swirl of changing laws and regulations that can only create uncertainty and instability. What is a binding contract one day becomes a worthless piece of paper the next day, because of a new Fed, SEC or Congressional rule. This process is made worse by the bankers themselves. Knowing that rules can be changed, they lobby to change rules to give themselves special exemptions and favors. Some of these are legitimate; others are rules that may permit poor lending practices or deceptive accounting practices.

Blame the mixed economy here. If government has the power to rewrite laws, people will approach government to have the laws re-written. Obviously, the solution is a capitalist government based on individual rights, so that no one can change laws in such a manner.

Because of the complexities in sorting out cause and effect, I would skip over all of 20th century history in trying to use it as an argument against fractional reserve banking, unless you can very carefully identify which problems are (allegedly) specifically tied to fractional reserve banking. To do that, you must also identify which crises were caused by central banking and government regulation so that you can separate them out. Instead of doing that, you are lumping everything together.

The bottom line is that I find your arguments ungrounded with concretes. Even your explanation of how banks work as intermediaries strikes me that way. Just how do banks work as intermediaries? What is the role of the various functions of deposit-taking, lending, and the issuance of money and other notes? Within that, how do reserves fit in? A solid, concretized understanding of this will go a long way in resolving this debate of fractional versus full reserve banking.

Respectfully,

GB

Link to comment
Share on other sites

With all due respect, you throw out so many floating ideas that it is impossible to engage them.

I was asked to show how and why FRB would cease to exist, not merely that FRB was bad. That is inevitably going to cover a lot of ground. I was also trying to give others' arguments a just hearing. I was "streaming" because I was trying to be fair.

As to why FRB is bad, I have just the one idea that I repeatedly said was the key to the whole thing: FRB does not lead to the creation of more real credit than would exist without it because the physical reality of what time-preference means is not altered by making book entries. If that is correct then FRB is dead in the water. If you want to support FRB then this is the issue you have to deal with.

Your key argument (for the 19th century) is basically that people were ignorant. Therefore, although millions of economic actors, both businesses and individuals, found it in their self-interest to participate in a system of gold-based fractional reserve banking, their decisions taken as a whole were motivated by ignorance.

If you don't accept how powerful ignorance can be as an explanation, how to deal with the fact that the bullionist controversy existed at all?

Many key concepts in economics we now take for granted were not formulated until late in the 19th century. Consider the marginal theory of value, which finally put the paradox of diamonds and water to bed. The industrial revolution had been in full swing for over 100 years by then, even though men really were ignorant of a key explanation of how the economy worked. Businessmen did not know it, and did not have to know it, in order to make their forecasts and business plans. Being rational and self-interested enough to succeed phenomenally in one field is not synonymous with the same in a related but more remote field.

Notice also that men were ignorant - and becoming increasingly so - of the true nature of how and why rational self-interest was crucial to the economy. It started with a semi-reasonable identification, as good as could be had with the prevailing philosophy, but then went downhill from there because of the influence of bad philosophy. Despite that ignorance businessmen were still perfectly capable of forging ahead because the details of rational self-interest weren't necessary to make forecasts of potential revenues in the coming years or of the benefits of this versus that machine. That ignorance is now catching up with us big-time.

These brilliant men included those who supported all manner of projects on moral grounds that we now know are grievously wrong. Economics crosses over from business practice to social and political concerns, were here even the great men were not completely rational and self-interested, never mind those they took advice from. For instance, Rockefeller's always tithing, Carnegie's and others' philanthropy, Robert Owen's socialist intellectual output, and so on. The ignorance at work is as clear as a bell, as is its source in irrational beliefs, even though these men were highly intelligent were doing this anti-selfish work for matters they held dear. Economics and finance were inevitably tied up in all these moral appraisals and social plans, and could not help but to have a measure of the irrational within them without good philosophy being used to prevent this. Being highly competent, rational and self-interested is not enough to dispel ignorance, and they did not always have that much. Given the bad philosophies, both moral and epistemological, how could they not be ignorant?? Even without unquestioned bad philosophies as hindrances there was still a lot of work to be done, and at the time it had just not yet been done.

In form, your argument reminds of the argument for the "New Soviet Man," the perfect, selfless man who will emerge once true communism is achieved.

You make it sound like I hold the moral component as a centre-piece, and that The Good of Society is the aim. I do nothing of the sort. Instead I just touch on morality, and note that it would make the difference between negligible and non-existent. It would act to underscore, not drive. The driver would be completely self-interested appraisals of benefits and costs that could be performed just as strongly by men not as explicitly concerned with morality as we. Indeed, I don't think the fully moral man wouldn't even be fully able to identify what the moral issue is until after the economics were explored. The only thing presupposed morally was a populace that votes in a laissez-faire government.

I cannot look at the achievements in railroads, steel, electricity, etc., and then say that the achievements in finance and banking were based on mass ignorance.

Sorry, that's argument to incredulity. I already gave the answer: knowledge of deeper consequences of financial practice is not strictly necessary to plan production and trade, nor to know how to finance these individual projects, even though those deeper consequences come back to influence the state of production and trade (and hence financial claims to them) in complicated and diffuse ways.

Second, I believe you are obfuscating the alleged problems of fractional reserve banking with actual problems caused by central banking and other government interventions.

The problem goes back well before modern central banking existed, and I have no need whatever to refer to modern active intervention to show why FRB is bad. The problem from government originates in a failure to act, not a wrong act. The only thing that modern intervention does is exacerbate a problem that had already existed for hundreds of years. I think I did say that much, but if I didn't make it clear enough then I apologise.

Because of the complexities in sorting out cause and effect, I would skip over all of 20th century history in trying to use it as an argument against fractional reserve banking

I don't use the 20th century as the main argument, I don't need to do so at all, and I don't think I ever did in any important way. That's why I objected to being lumped with Murray Rothbard and raised the entire bullionist controversy of 100 years prior.

The bottom line is that I find your arguments ungrounded with concretes. Even your explanation of how banks work as intermediaries strikes me that way. Just how do banks work as intermediaries? What is the role of the various functions of deposit-taking, lending, and the issuance of money and other notes? Within that, how do reserves fit in? A solid, concretized understanding of this will go a long way in resolving this debate of fractional versus full reserve banking.

Of course. I have no quarrel with that. I have every intention of putting it all down on paper, complete with proper concretisation. The problem is that it's not something that can be dealt with in a few paragraphs suitable for this forum. If touching on bits and pieces is causing grief, then the only issue I would see addressed is the one that I have always begun with: that FRB does not increase the provision of real credit. Everything else is trivial in comparison.

Equally respectfully,

JJM

Link to comment
Share on other sites

You need to look up how FRB actually works to generate a "credit multiplier".

Okay, I'm with you now on the credit multiplying effect - I was forgetting to count the recycle of loaned cash back into the bank. So the credit multiplier is equal to

SR(1 - RR) / RR

Where SR=Savings Rate (avg pct of money not held in cash) and RR is the reserve rate. Smaller RR blows up the amount of money.

But I'm still lost on something here. If every dollar I have is held in cash, whether it is in my mattress or in my bank, then by definition I am not investing. Further, any investment I make, whether it be the purchase of stock, bonds or a loan to an individual, results in that cash being returned into the economy, while I still hold that investment, which results in an effective money multiplier. If I use that stock or bond or loan as a value to be traded for other value, the translation to money becomes real (subject to variations in its value).

Now at an individual level, if I did business that way, I'd have a better grasp of what was actually happening to my money, but at an aggregate level, if all loans were made by individuals, the amount of value, or effectively, of money, floating around would be governed not by a few experts trained in the arts of patience and perseverance; but by me and you and my crazy Aunt Clara with the cats. Which system do you think has more stability? Granted a run on a bank would cause a problem, if the bankers did not know what to do in that case, but then, where does the money go? Given the alternative between cash in the mattress and deposit earning interest, the natural tendency is for people to get their money back in the bank. If it goes back into any bank, the banks can make arrangements to transfer money around, and the need to produce cash is averted.

Furthermore, the banks provide what is recognized by investors as the most effective long term investment strategy, that is, diversification. When you put your money in the bank for loans out, you are effectively investing in the economy, not in any one security. Further, you are investing in purchased commodities, which, if the bank is doing its job, are valued at more of the value of the loan, so that if any particular loan should go bad, value can still be collected from the borrower. The same is not true in the purchase of stocks. The bank's service provides (hopefully) better valuation of potential loans than you could do yourself; efficient, evolved processes that make the generation of loans go smoothly; and economies of scale that allow them to handle the the massive amounts of loans, payments, repossessions, etc. with far greater efficiency than we could ourselves. Those factors must result in a far more secure form of investment than could be offered elsewhere, especially since the bank's interest are best served by protecting its (your) money from risky borrowers, and by providing the highest interest incentives it can to generate depositors. I don't see any way of getting around the efficiencies and inherent colineation of self interest between investor and investment agent that you see in the case of banks, but probably not anywhere else.

Finally, you have to admit, that even though the fractional reserve system increases the amount of money on a bank's books, on average, people aren't using a large percentage of their deposited money at any given time. In reality, the amount of effective money being used for exchange in the economy is a small percentage of the total in all the accounts held by the banks. Seen this way, fractional reserve banks can be seen as providing a stabilizing effect on money supply, buffering the economy from the vagaries of individual cash management decisions and providing a smooth and objectively evaluated adjustment of the money supply to the economy, which, if kept in sync with economic growth and contraction, tends to stabilize prices, which is probably far more important to individuals than the stability of the aggregate money supply.

On edit: I just want to add that I do not intend this last as a support for central planning in adjusting the money supply. I believe the aggregate decisions of depositors and borrowers, along with the response of interest rates to supply and demand, tend to synchronize the effective money supply to the ebb and flow of economic growth.

Edited by agrippa1
Link to comment
Share on other sites

agrippa: Just to get it clear, you advocate letting the market decide between FRB's or full-reserve banks correct? In my posts I am simply speculating as to whether or not FRB's would be widely used in a truely laissez-faire economy. But I do not side with Rothbard in saying FRB should be illegal. I believe the market should figure it out, only, I am uncertain which form the market would side with.

Assuming a laissez-faire, rights respecting economy: Would you personally use a FRB? Now, if you were a business owner, would you use an FRB to hold your deposits and would you accept FRB notes? If so, would you accept them at their face value or at severe discounts to their face value?

Link to comment
Share on other sites

agrippa: Just to get it clear, you advocate letting the market decide between FRB's or full-reserve banks correct? In my posts I am simply speculating as to whether or not FRB's would be widely used in a truely laissez-faire economy. But I do not side with Rothbard in saying FRB should be illegal. I believe the market should figure it out, only, I am uncertain which form the market would side with.

Assuming a laissez-faire, rights respecting economy: Would you personally use a FRB? Now, if you were a business owner, would you use an FRB to hold your deposits and would you accept FRB notes? If so, would you accept them at their face value or at severe discounts to their face value?

To all the questions: Absolutely.

I believe when people look at their alternatives, they will recognize the value of having a low risk investment with virtually guaranteed instant access through pooled resources. -- After all, we don't all have a fire engine parked outside our home. (but what if all our houses catch fire at the same time??!!! :o )

Since every dollar of an FRB is backed and secured by capital of at least as great a value, there should be no question about the value of the note.

I was interested to read recently that the New York Bank of the United States, the poster child for FRB woes, and whose failure in December 1930 was the first big rock in the avalanche of bank failures, eventually paid back 83.5 cents of every dollar deposited. That may not sound so stellar until you realize that during the ensuing two years, while they were liquidated capital to pay depositors, the dollar value of everything (including that capital) plummeted, and each of those dollars they were paying back gained 23-27% in real value. Had they survived the initial panic, that is, had cool heads realized that their money, while temporarily inaccessible, was still secured by real assets, the bank almost certainly would not have failed.

As it was, the customers of a failed FRB bank realized an annual real-value rate of return of between 1.3% and 2.9% on deposits (depending on whether you use CPI or PPI to measure price deflation) over the two years following the collapse - because the bank properly collateralized all of its loans. During the same time, a stake in the Dow would have lost 53% of its real value.

Tell me again about risk?:)

Link to comment
Share on other sites

Which system do you think has more stability?

If you don’t want to spend the cash you have, and just hold onto it for a bit rather than invest it, that’s going to affect the amount of money circulating around but not the total amount of money in existence. Without FRB, it doesn’t matter whether you stuff it in a mattress, put it in your bank account, or Aunt Clara lines her kitty boxes with it: the total amount of money is unchanged. As you pointed out later, if you or Aunt Clara spend some it is not going to make much difference because that little bit you and Aunt Clara have sitting around is tiny compared to total spending. Everyone else can then easily get use to how much people regularly spend, so it’s as stable as any monetary system is ever going to get.

On the other hand, money is multiplied beyond the physical cash though FRB into a much larger amount in the totality of people's accounts. However, that total amount of money can change quite considerably depending on whether the cash is held in person or put into the bank. If you withdraw some cash from your bank account, the difference between what the bank can multiply with it and that amount you withdraw just vanishes into thin air. Precisely because the credit multiplier and create and destroy a large amount of money the total amount of money is more exposed to Aunt Clara’s craziness. If the credit multiplier is say 8, then it means her ability to influence total spending is now 8 times greater than it was before! It is not always significantly unstable because as you say most of the time the cash will go back to banks again to multiply it back up again, but the going to and from thin air doesn’t happen instantly. That makes it harder for everyone to get use to how much people spend, so it is less stable than it would be without FRB in the first place.

Fractional banking doesn’t increase stability, it reduces it. Diversification of what the bank invests the money in doesn’t change this, no matter how expert they are at it. The money in Aunt Clara’s kitty boxes or her accounts is hers to do with as she pleases, and the bankers either like or lump it. The only thing they can do is make it harder for her to withdraw cash, such as through having daily withdrawal limits or prior-notice periods, but each of these actions is one-by-one a step away from what fractional reserve banking means.

(I’ve rearranged the order of what you said, slightly. I hope you don’t mind.)

you have to admit, that even though the fractional reserve system increases the amount of money on a bank's books, on average, people aren't using a large percentage of their deposited money at any given time.

Without FRB, John Doe deposits $100. The bank then has $100 in cash sitting in the vault and counter tills. It physically sits there, unused. With FRB and a multiplier of 6, John Doe deposits $100. The bank multiplies it to $600 through cycling loans and deposits. This $600 is then made up of $500 in loans, plus the $100 in cash. Once again, that cash physically sits there, unused. As far as the real cash is concerned, nothing has changed. The cash is always going to be somehow unused. The only difference is that initially the $100 in cash backed $100 in accounts, while later the $100 in cash is met with $500 in loans to back $600 in accounts. The fundamental issue with FRB is whether or not that extra $500 in loans is a real addition to the economy.

My answer is no, because that new $500 in money only causes an inflation that devalues the entire set of all loans in the economy. If the total value of all loans before were say $2000 and then the new $500 takes the total to $2500, I am saying that this $2500 is worth just the same in real terms as the $2000 was before. The only things that change are, first, that the owners of the previous $2000 go from having 100% of total credit to having just 80% of total credit and the banks getting the other 20% (which it shares with the depositors), and second, that the total amount of real goods that these loans paid for wont permanently change for the better because people’s physical desire to invest rather than consume hasn’t changed.

It’s in figuring out this second part that the real work of proving why FRB doesn’t contribute anything is done. The basics is to show the connections between the movements of financial credit and interest rates with what happens in the physical world of real goods and real incomes. At the outset, the new credit means more funding to buy physical investment by the borrowers, but that means more competition so it lowers real profits and interest. This motivates the existing investors to start liquidating or stop renewing some of their current financial investments. They will keep on withdrawing business and credit until rates of profit and interest are pushed back up to where they were before. In the physical world this means that real goods are either sold off to the new borrowers or are just scrapped: to the extent new ones are physically made, existing ones will be physically scrapped or abandoned. When the dust settles the increase in some real goods at the outset will be offset by the decrease in other real goods later to give a roughly constant amount. The physical world has to come back to that because that's what corresponds to people's physical attitudes towards time and risk, which have not changed in favour of more real credit. Everything comes back to roughly where it was (or worse), except for the inflation having pushed up all prices, who owns what being rearranged, and the finance system now being more unstable than it was before. Nothing beneficial has been accomplished.

It’s more complicated than that, but that’s the process in a nutshell. What’s missing from everyone else’s analysis is that for every percentage point that financial credit goes up through fractional reserve banking, the value of a single unit of that financial credit eventually goes down by the same percentage point. The total numbers of loan values may go up, but in the end their total real value doesn’t. Not seeing this is the same mistake made by people who think inflation makes us better off.

It doesn’t help that there are an ‘eventually’ and an 'in the end' stuck in there. Things don’t happen instantly. That part creates confusion and waste, because it costs resources to shift all those real goods around even though there's nothing actually gained overall in doing so. This is the same bad effect that inflation has. No surprise there, because the practice of FRB is nothing more than a perverse variant of inflationism.

The bank's service provides (hopefully) better valuation of potential loans than you could do yourself; efficient, evolved processes that make the generation of loans go smoothly; and economies of scale that allow them to handle the massive amounts of loans, payments, repossessions, etc. with far greater efficiency than we could ourselves. … I don't see any way of getting around the efficiencies and inherent colineation of self interest between investor and investment agent that you see in the case of banks, but probably not anywhere else.

Yes, this is the last major detail. What’s left to explain after showing that no real capital is generated, and that "unused money" is a non-issue, is the technical detail of how banks work as intermediaries with economies of scale in the absence of FRB.

The simple answer is that without FRB people will pay more attention to their available choices about what short-term credit products they can buy from the bank, because the de-multiplication process that will happen under the introduction of laissez-faire will temporarily increase the rates of return that can be had on these products. Nothing new needs to be done as all these products already exist today. Any decent bank branch today will have fliers and brochures for things like christmas club accounts, term deposits, CDs, cash management trusts, and so on. In my branch the walls and benches are plastered with fliers, the stands holding brochures double as crowd-control devices. During the de-multiplication, bank head offices will send the word down to retail operations to increase sales efforts. Without FRB the trade in these products will increase as a proportion of the banks’ retail business, acting to help fill the hole left by the elimination of the multiplied-up credit.

You needn’t worry about economies of scale, because the banks are already experts at using their economies of scale to invest efficiently the funds they get when you buy these products. In fact, in the process of increasing the trade in them the scale of the banks’ operations in investing the funds they get will increase, thereby allowing for even more of the efficiency people want.

Outside of the banking system, that same temporary increase in interest rates will pull in more investors to make loans directly to businesses or via non-bank intermediaries, also doing its bit to fill the hole. These loans will just retake their rightful place as a more significant proportion of total credit than they have now. As with bank products, the lending will continue until the interest rates are back to where they were before, with the difference being an increased proportion of the total credit being not in bank customer’s hands. The banks might get upset at losing some of the custom to independent financial advisers etc, but that's their problem.

In the end the hole will disappear as though it never existed. This is because the driver of the entire capital-provision system is unchanged. That driver is people's physical preferences whether to consume now or invest to consume later. Altering reserves one way or the other does not change people's preferences, and those preferences will come to reassert themselves.

tends to stabilize prices, which is probably far more important to individuals than the stability of the aggregate money supply.

No, price stabilisation is not knowing people’s aim. As producers, individuals want predictability rather than simple stability. As consumers, they want ever more value for money rather than the same year in year out.

JJM

Edited by John McVey
Link to comment
Share on other sites

The fundamental issue with FRB is whether or not that extra $500 in loans is a real addition to the economy.

My answer is no, because that new $500 in money only causes an inflation that devalues the entire set of all loans in the economy. If the total value of all loans before were say $2000 and then the new $500 takes the total to $2500, I am saying that this $2500 is worth just the same in real terms as the $2000 was before. The only things that change are, first, that the owners of the previous $2000 go from having 100% of total credit to having just 80% of total credit and the banks getting the other 20% (which it shares with the depositors), and second, that the total amount of real goods that these loans paid for wont permanently change for the better because people’s physical desire to invest rather than consume hasn’t changed.

Your argument in essence rests on this assertion: "that new $500 in money only causes an inflation that devalues the entire set of all loans in the economy."

Here you have a logical flaw, because you are very clear in your definition of inflation as an increase in the supply of money faster than the rate of increase of an (arbitrary) standard commodity, and not an increase in prices. The above statement implicitly equates inflation of the money supply with price inflation across the economy. While it might seem safe to make that assertion, especially given the large amount of inflation involved, I am going to argue that in this case, the inflation does not cause prices to rise.

I think you asserted earlier that the total amount of resources available is stable in the economy. I would dispute that on two grounds: First, that industrial production transforms resources in one form into resources in a more valuable form, creating value and consequently, wealth, out of thin air. (out of brains and sweat, actually) Second, that privately owned capital, i.e., wealth, once accumulated is not "in" the economy, and can enter the economy at any point, looking to the economist, like value appearing out of thin air.

When a person gets a loan, they see an opportunity to turn a resource into a wealth creating venture. In order to purchase it, they must persuade the current owner (or producer) to relinquish the property in return for money. If you trace the flow of dollars backwards through time you find that either the borrower/purchaser is paying for newly created value, or he's paying for raw materials newly dug from the earth, or he's paying an owner to place his capital back into the economy,or he's transferring an existing loan from the (original) seller to himself. In any of these cases (or more likely, some combination), the new loan consists of (is backed by) either a transfer of loan (that is, not a net increase in loans), the creation of wealth through industrial production, or the transfer of capital from private ownership into the economy. The total real value of the entire economy has risen by exactly the amount of the loan, minus any part of the purchase that had been security on a previous loan. As long as prices are stable, which they will be, if a stable commodity is used to back the currency, the increase in the supply of money by FRB exactly equals the increase in the total value of the economy. In this way, FRB dampens fluctuations between the amount of gold (for instance) and the size of the economy, which fluctuations lead to changes in prices which can destabilize the decision processes of the individual.

Edited by agrippa1
Link to comment
Share on other sites

Your argument in essence rests on this assertion: "that new $500 in money only causes an inflation that devalues the entire set of all loans in the economy."

Here you have a logical flaw, because you are very clear in your definition of inflation as an increase in the supply of money faster than the rate of increase of an (arbitrary) standard commodity, and not an increase in prices.

You're right that it's a flaw, but not a logical one. Change the sentence to read "the new $500 in money is only an inflation ..." and it all works perfectly. It does fit in with how I previously defined inflation.

I think you asserted earlier that the total amount of resources available is stable in the economy.

No, I was initially comparing the same one point in time as would be the case without versus with fractional reserve banking. At that point in time there is indeed only so much in the way of resources, all in a particular structure. After that, I was also separating out the effects purely of the introduction of FRB, leaving aside other factors that lead to economic growth such as population, technology, and the increase of foreign trade.

You're also confusing the two concepts of real capital and financial capital. Real capital is all the physical wealth that exists, organised in a certain way to produce physical output. Financial capital is all those sets of claims to real capital. On a balance sheet, the real capital is the assets while the financial capital is the debt and equity. What people want is to have the consequences of using the real capital. It is the physical world that sets the terms for the financial world. Although the financial world can run ahead or behind the physical world temporarily, sooner or later the physical world will yank the financial world back into line because it's the physical world that people really care about. If people's expectations and requirements for the real world don't change then any increase in the number of measurement units in the financial world must only result in the total being devalued down to take the real value of the total back to equality with that real world.

The problem with FRB is that it only temporarily makes a new venture look good. Every extra physical investment that a new borrower starts up, turning resources into goods, will later be offset by disinvestment and the scrapping of other goods elsewhere, leaving us no better off in aggregate. Newly created value today must turn into scrapped equal value elsewhere tomorrow (unless something unrelated to reserves makes one of these values better). You see the first part alright, but are missing the second part. Have a look again at what I wrote, keeping in mind the distinction between real capital and financial capital: it is the financial capital that can come from and disappear back into thin air, because except for that part of it that is real commodities it is nothing more than ink or electrons recording people's claims and opinions.

The total real value of the entire economy has risen by exactly the amount of the loan, minus any part of the purchase that had been security on a previous loan. As long as prices are stable, which they will be, if a stable commodity is used to back the currency, the increase in the supply of money by FRB exactly equals the increase in the total value of the economy.

No, prices wont be stable. FRB squeezes profits by temporarily increasing competition, and so eventually causes real value to be taken away again because profits are not good enough. That causes competition to come back down again to where it was before. This roller-coaster investment activity makes prices bounce all over the place, not stabilise them. Having a stable commodity as the basis doesn't affect that part.

JJM

Link to comment
Share on other sites

You're right that it's a flaw, but not a logical one. Change the sentence to read "the new $500 in money is only an inflation ..." and it all works perfectly. It does fit in with how I previously defined inflation.

The logical flaw still exists in equating monetary inflation necessarily with price inflation. The false premise behind that flaw is here:

No, I was initially comparing the same one point in time as would be the case without versus with fractional reserve banking. At that point in time there is indeed only so much in the way of resources, all in a particular structure. After that, I was also separating out the effects purely of the introduction of FRB, leaving aside other factors that lead to economic growth such as population, technology, and the increase of foreign trade.

Here, the flaw is that introduction of FRB at one point in time will entail an instantaneous increase in loans at that point in time. This is clearly not what would happen, if the hypothetical were realized.

That loans would increase demand for capital is not in question. The question is whether that increased demand will lead to nothing more than an increase in capital prices. This view requires a static model of the economy (i.e., a fixed amount of real capital, all tied up as financial capital), viewed at a single point in time.

The assumption here is that all capital is tied up in loans, which is clearly not the case. As demand for capital rises, privately owned capital will be drawn into the economy in the form of secured loans. This means that as demand goes up for capital, and incrementally drives prices up, so supply also increases in response, as capital owners reach the price point that is higher than the capital's real value to them. In the case of increasing demand for produced goods, the increase in prices fetched for those goods will drive an increased supply, not quite matching the demand, and resulting in increased production and higher prices.

That establishes that the increased demand for capital will result, at least partly, in an increased supply. The rest of the demand will be eaten up by higher prices. Now the question is, are the increased prices for capital justified? (i.e., do they reflect an increase in value, as measured against some standard)

To get that answer you have to consider why the borrower is purchasing the capital and why the owner is selling it. A part of that answer is that with the increased opportunity to own capital, the production barrier to entry is lowered and competition is increased. This leads partially to drive innovations to lower the cost of production, and partially to a lower threshold for profitability by newcomers (compared to established firms). The former will result in an increased real value of the capital, as the profitability potential of production rises. The latter is problematic. The lower profits and higher production will lead to lowered prices for the product being produced. The question here is: do the total profits for the industry as a whole go up, or down as a result? I think the answer to that depends on an evaluation of the new situation of risk v. ROI. As barrier to entry goes down, risk decreases, and required ROI decreases as well. You could find that total profits drop as a result, but when you factor in the risk I think you'll find that on average the total profits, i.e., the total added value of the industry, goes up.

Bottom line is I think you're right that some of the increased demand for loans is eaten up by increased prices of capital, but I believe I've shown that the increased demand leads necessarily to an increase in supply, and also to an increase in industrial efficiency, both of which are net economic gains.

You're also confusing the two concepts of real capital and financial capital. Real capital is all the physical wealth that exists, organised in a certain way to produce physical output. Financial capital is all those sets of claims to real capital. On a balance sheet, the real capital is the assets while the financial capital is the debt and equity...

stop!

You're mixing up concepts of ownership and debt. On the balance sheet, debt is what is owed (to the bank or to bondholders), but equity is that part of assets (after debt) which is owned by stockholders.

Assuming for a moment that the balance sheet in question represents non-productive capital (to simplify out consideration of present value of future profits, etc.), suppose a man goes to the bank for a loan to buy the assets. He takes the borrowed money and purchases the assets from the entity. The entity pays off its creditor with part of the money, and the rest is divided between stockholders.

What's happened? Part of the loan is simply a transfer of debt from the old creditors to the bank, but another part is the transfer of capital from private ownership (stockholders' equity) into the financial system to back a loan.

The increase in money supply is exactly offset by the value of the capital introduced to back that money. Again, as long as there is a stable standard against which prices are measured, the increase in price of capital represents an objective increase in value of that capital.

Link to comment
Share on other sites

My first objection to FRB is a moral one. A corollary of FRB is that banks are allowed to create new money. In doing so, they reduce the value of all other money through inflation. Net savers are penalized for the benefit of net debtors, which is immoral.

I also object to FRB on the grounds of general banking stability. History shows that over the long term, FRB are subject to failure, bank runs, etc. -- central banks were created as a backstop to help limit the damage caused by banking failures. It doesn't appear to be possible to have FRB without central banks, and without the arbitrary fiat money creation that comes with them.

My final objection is that FRB requires fiat money. With something like a true gold standard, FRB isn't possible.

Link to comment
Share on other sites

My first objection to FRB is a moral one. A corollary of FRB is that banks are allowed to create new money. In doing so, they reduce the value of all other money through inflation. Net savers are penalized for the benefit of net debtors, which is immoral.

The monetization of assets ("creation of new money") does not reduce the value of the money. Under a gold standard, the value of a dollar cannot fall below the value of its equivalent in gold: if it did, people would redeem their dollar bills for gold coins and melt the coins for profit.

That being said, why do you think that an economic action that benefits some people and "penalizes" others is necessarily immoral? If I buy my gas from Exxon and not Texaco, I am benefiting Exxon and "penalizing" Texaco. Does that make me immoral?

My final objection is that FRB requires fiat money. With something like a true gold standard, FRB isn't possible.

??

Link to comment
Share on other sites

The monetization of assets ("creation of new money") does not reduce the value of the money. Under a gold standard, the value of a dollar cannot fall below the value of its equivalent in gold: if it did, people would redeem their dollar bills for gold coins and melt the coins for profit.

Monetization of assets is not the same thing as creating new money. New money is created by banks all the time backed by nothing more than a promise from the borrower that it will be repaid.

Under a full gold standard, FRB isn't possible. A full gold standard means that all currency is redeemable for gold at any time. With FRB, if I deposit $1000 worth of gold, the banking system as a whole can create $9000 worth of new money (assuming a 10% reserve ratio). That new money is entirely inflationary, and as such devalues the money that was previously in circulation.

On a gold standard, money is defined in terms of gold: $20 = 1 oz, or something like that -- so obtaining a profit by melting coins isn't as easy as it might seem. However, the gold could be exchanged for a foreign currency -- and in fact that's exactly what happened in the 1920's when the Fed inflated the money supply prior to the Great Depression: the dollar lost value, and huge amounts of gold were moved out of the country as a result.

That being said, why do you think that an economic action that benefits some people and "penalizes" others is necessarily immoral? If I buy my gas from Exxon and not Texaco, I am benefiting Exxon and "penalizing" Texaco. Does that make me immoral?

If I buy gas from one company instead of another, my actions are voluntary, and the profits of the companies involved are derived from the free market. I am not taking anything from one company for the profit of another.

If I am a net saver and you borrow money from a FRB, you are stealing from me. The value of my money declines, without my consent, through the process of inflation.

If you steal from me to feed your family, that "economic action" benefits you, but it's still theft, and it's immoral.

Edited by AceNZ
Link to comment
Share on other sites

Bottom line is I think you're right that some of the increased demand for loans is eaten up by increased prices of capital, but I believe I've shown that the increased demand leads necessarily to an increase in supply, and also to an increase in industrial efficiency, both of which are net economic gains.

That is the bottom line, but the key is that FRB does not change what people find acceptable as the real returns on capital. People expect certain rates of return on their investments, and if they don't get those returns then they will pull their investments out. Any increase in real capital at the outset will be undone later by a matching decrease in capital, resulting in no economic gains. In the finance books, the increase in one type of lending crowds out another type of lending but with the twist of devaluing everything. If you can wrap your head around that then everything I've written falls into place.

JJM

Link to comment
Share on other sites

Join the conversation

You can post now and register later. If you have an account, sign in now to post with your account.

Guest
Reply to this topic...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoji are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...
 Share

  • Recently Browsing   0 members

    • No registered users viewing this page.
×
×
  • Create New...