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Fractional Reserves

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John McVey
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For those with a serious interest in this topic, I strongly recommend the book, "Breaking the Banks: Central Banking Problems and Free Banking Solutions" (1990) by Richard Salsman. I read it years ago and when I have time I will re-read it. It is not specifically about fractional reserve banking, but it is a historical analysis of banking in the 19th and 20th centuries.

Some interesting facts. During the free banking era (1837-1863), when banking was closest to laissez-faire, reserve ratios were around 42%. That compares with today's reserve ratios of something like 5%. In the free banking era, banks willingly chose to keep very large reserves. It was not 100% reserve banking, but 42% reserve banking.

Salsman shows how reserve ratios progressively fell as the government socialized credit more extensively. In the post-Civil War period, the ratios were 20%-25%. Then after the Federal Reserve was established in 1913, ratios fell further until today's approximately 5% levels.

Such data suggests to me that the problem is not fractional reserve banking, but central banking. Remember, central banking is about centralizing reserves. Reserves are principally held at the central bank, instead of at the individual banks. Also, a central bank acts as a lender of last resort. Finally, a central bank inflates. These facts induce banks to keep minimal reserves. With minimal reserves, the "multiplier effect" is greatest and the problems attributed to fractional reserve banking emerge.

Thin fractional reserve margins are the result of central banking. The culprit is central banking, not the fact that banks operate with less than 100% reserves.

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As demand for capital rises, privately owned capital will be drawn into the economy in the form of secured loans.

Drawn into the economy from where? How is it possible for capital to exist outside of the economy?

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.

What you're describing is the process by which inflation distorts capital allocation, in violation of the free market.

That establishes that the increased demand for capital will result, at least partly, in an increased supply.

The supply of capital doesn't increase; it just gets reallocated. The results are the typical booms and busts of the business cycle.

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Such data suggests to me that the problem is not fractional reserve banking, but central banking.

What problem are you talking about?

One of the biggest problems with fractional reserve banking is that it is an enabler of the hidden tax of inflation. Although central banking increases a bank's ability to inflate without suffering a run and going out of business, eliminating the central bank doesn't solve the inflation problem entirely (although inflation is definitely reduced with higher reserves).

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What problem are you talking about?

One of the biggest problems with fractional reserve banking is that it is an enabler of the hidden tax of inflation. Although central banking increases a bank's ability to inflate without suffering a run and going out of business, eliminating the central bank doesn't solve the inflation problem entirely (although inflation is definitely reduced with higher reserves).

I am referring to the problems described in John McVey's posts.

As for inflation, that can only occur if there is a systemic decline in the fractional reserve percentage for the banking system as a whole. If that percentage is stable, there is no inflation. Interestingly, during the free banking era I describe, the reserve percentage for the entire banking system was remarkably stable at around 42% plus/minus a few percentage points.

Only the existence of a central bank could permit system-wide reserve percentages to decline in a secular manner, as they have during the 20th century. Even now that process continues as the central bank has authorized government-sponsored lenders such as Fannie Mae and Freddie Mac to keep smaller reserves so they can lend out more money to homebuyers. That is inflation.

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During the free banking era (1837-1863), when banking was closest to laissez-faire, reserve ratios were around 42%. That compares with today's reserve ratios of something like 5%. In the free banking era, banks willingly chose to keep very large reserves. It was not 100% reserve banking, but 42% reserve banking.

Salsman shows how reserve ratios progressively fell as the government socialized credit more extensively. In the post-Civil War period, the ratios were 20%-25%. Then after the Federal Reserve was established in 1913, ratios fell further until today's approximately 5% levels.

Doesn't this lend itself to support the case that under a truly free laissez-faire economy, 100% reserve ratios would be chosen by the markets? If it was government socialization of credit which caused reserve ratios to fall to 5%, then why wasn't it government socialization of credit which caused reserve ratios to fall to 42%?

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Doesn't this lend itself to support the case that under a truly free laissez-faire economy, 100% reserve ratios would be chosen by the markets? If it was government socialization of credit which caused reserve ratios to fall to 5%, then why wasn't it government socialization of credit which caused reserve ratios to fall to 42%?

There was no socialization of credit during the free banking era. There was the complete privatization of credit. All notes were privately issued by banks. Government (largely) did not issue notes.

Before the free banking era, there were the First and Second Banks of the United States, early central banks. I do not know what reserve ratios were like then. Before that, during our colonial and early revolutionary period, the United States had a very small, primitive banking system. It probably suffered from too few notes in circulation. The coins and notes that did exist were generally foreign. Spanish gold coins circulated as did notes drawn on British banks and on the one or two U.S. banks then in existence.

In contrast, the free banking era was robust in many ways. Salsman goes into details. I can say that money was not just good as gold; it was better than gold. It gained in value throughout that period because the money supply was directly tied to the supply of gold. It gained in value as economic output grew at a faster rate than money did. Banks had to rely on their own private reserves of gold to redeem the currency they issued. Because there was no central banker of last resort to fall back on, the banks (excluding some dishonest ones) had to scrupulously maintain a large base of gold and high quality paper as reserves. It was the lack of a central bank that enforced prudent banking practices.

As for inflation, mathematically it does not happen if the reserve ratio is steady. Money simply grows at a steady percentage anchored by the growth rate in gold.

There are good reasons to maintain less than 100% reserves. The main reason is that it economizes the supply of costly-to-store and maintain specie. The experience of the free banking era supports the premise that banks are fully capable of deciding for themselves how much gold to retain as reserves. Moreover, it is highly likely that that percentage is less than 100%.

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Drawn into the economy from where? How is it possible for capital to exist outside of the economy?

Any capital owned outright is outside of the economy, from a financial point of view. Any product that adds value to materials from which it was made represents value created by man, and ready to enter the economy. Any raw commodity dug up from the earth or harvested from her soil represents new capital-forming materials which can then enter the economy. To deny that capital can enter the economy is to assert that all capital in existence today has always been in existence. It is a point of view that requires suspension of time, which is a premise that invalidates any conclusions drawn.

What you're describing is the process by which inflation distorts capital allocation, in violation of the free market.

No, what I'm describing is a process by which capital enters the market without the need to print more money, or, in the case of a gold standard, without unnecessarily increasing the value of the backing commodity above its market value to allow a greater amount of financial capital to exist under a stable amount of currency.

The supply of capital doesn't increase; it just gets reallocated. The results are the typical booms and busts of the business cycle.

see above

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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

You're basing your argument, then, on two premises:

First, that risk-adjusted ROI for a given piece of capital used in a given capacity is identical for the outright buyer and for the borrowing buyer.

Second, that the amount of real capital in an economy does not increase over time.

Sorry, but I can't wrap my head around either of those.

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I am referring to the problems described in John McVey's posts.

As for inflation, that can only occur if there is a systemic decline in the fractional reserve percentage for the banking system as a whole. If that percentage is stable, there is no inflation. Interestingly, during the free banking era I describe, the reserve percentage for the entire banking system was remarkably stable at around 42% plus/minus a few percentage points.

Only the existence of a central bank could permit system-wide reserve percentages to decline in a secular manner, as they have during the 20th century. Even now that process continues as the central bank has authorized government-sponsored lenders such as Fannie Mae and Freddie Mac to keep smaller reserves so they can lend out more money to homebuyers. That is inflation.

I'm in complete agreement with this. The current FRB fraction is far less than it would be without the moral hazard created by the Fed insuring banks with fiat currency.

In a free banking system the depositors and banks would weigh the risks involved in fractional reserves with the benefits of drawing interest. With the fraction at 100%, there is no interest and no risk. As the fraction drops marginally from 100%, the investor's return rises linearly with the percentage decrease, while the risk rises proportionately to the reserve fraction. (For instance, as the fractions drops from 99% to 98%, the amount of return doubles, while the amount of risk rises by, at most, 99/98 - 1 = 1.02%. As the fraction continues to fall, percentage point by percentage point, at some point the marginal increase in return exactly equals the marginal increase in risk, and any further decrease in the fraction decreases the risk-adjusted return.

When the central banks implicitly or explicitly insure depositors against losses, the amount of marginal risk is artificially decreased, bringing the break even point lower and lower. In the case where a large government is insuring a small bank, and the risk of a total economic collapse is seen as zero, the fraction will fall as low as the bank deems is necessary to sustain worst case day-to-day deposit and withdrawal transactions.

That is where the danger of FRB lies, and it is directly attributable to the Federal Reserve and fiat currency. Without fiat currency and a nanny state insuring depositors, FRB acts efficiently to optimize the production and growth of the economy, and the fraction reflects an acceptable risk-adjusted return on depositors investments.

Edited by agrippa1
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In a free banking system the depositors and banks would weigh the risks involved in fractional reserves with the benefits of drawing interest. With the fraction at 100%, there is no interest and no risk. As the fraction drops marginally from 100%, the investor's return rises linearly with the percentage decrease, while the risk rises proportionately to the reserve fraction. (For instance, as the fractions drops from 99% to 98%, the amount of return doubles, while the amount of risk rises by, at most, 99/98 - 1 = 1.02%. As the fraction continues to fall, percentage point by percentage point, at some point the marginal increase in return exactly equals the marginal increase in risk, and any further decrease in the fraction decreases the risk-adjusted return.

Not quite. At least I think not.

If the bank cannot lend deposits out, what is its source of income? I believe you would have to pay it money, just to cover the cost of storing those gold (okay, silver if your budget is like mine) bricks safely and securely. (Have you ever priced a vault, or even a good burglar-resistant safe?)

E-gold accepts cash, buys gold in your name, and lets you transfer it to other customers' accounts--if both you and your buyer/seller have e-gold accounts, you can do the deal in gold. They sound like the epitome of what a bank would be with real money and no fractional reserve. But they charge both a transaction fee (to the recipient) and an agio fee (for storage), which is a percentage per time period. (BTW they also offer silver, platinum and palladium accounts.)

If the bank cannot lend your money out they have no source of income (in that case they aren't a bank, they are a warehouse to store money (hopefully real precious metal money). So it would take some less-than-100% fractional reserve requirement just to keep your money and not have to charge you fees to do so. I do not know what percentage it would be before a bank can offer "free" savings accounts. (Checking accounts could return to the no-interest, fee-driven model--there you are paying for the convenience of checking.)

Perhaps the solution is to completely ditch the concept of a savings account as we know it, and have banks explicitly offer "shares" of their investment pool instead. You would either be paid in more shares, or they'd raise the value of a share, in order to pay dividends on the investment. In order to get your money back, you would have to sell your shares. Now this is what *actually* is going on with a savings account (My credit union refers to shares and dividends in its statement), which is why I don't really have a beef with FRB. My money is not actually in the account; it has been invested, just as the money I use to buy stocks is invested. (I could even pay someone for something with stocks, theoretically.) But saying so in this way would make it explicit, instead of pretending the money in a savings account is liquid cash, and the whole argument would go away.

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As for inflation, that can only occur if there is a systemic decline in the fractional reserve percentage for the banking system as a whole. If that percentage is stable, there is no inflation. Interestingly, during the free banking era I describe, the reserve percentage for the entire banking system was remarkably stable at around 42% plus/minus a few percentage points.

Some initial inflation happened that took the fraction from 100% down to some lower number. To say that's acceptable is like saying that it's OK if a thief only steals from you once. It's still immoral.

Also, inflation can still happen with a constant reserve fraction, if new reserves are introduced. On a gold standard (without debt-based money), that could happen with increased foreign exchange reserves, for example.

Any capital owned outright is outside of the economy, from a financial point of view. Any product that adds value to materials from which it was made represents value created by man, and ready to enter the economy. Any raw commodity dug up from the earth or harvested from her soil represents new capital-forming materials which can then enter the economy. To deny that capital can enter the economy is to assert that all capital in existence today has always been in existence. It is a point of view that requires suspension of time, which is a premise that invalidates any conclusions drawn.

Perhaps you have a different definition of the term "economy" than I do.

I don't deny that new capital can enter the economy. I do deny that existing capital isn't part of the economy. I don't understand the concept of something existing outside of the economy, provided that its existence is known. Even money buried in my back yard is still in the economy. Of course if I die or forget that it's there, then it's no longer in the economy. Until then, I've made a conscious choice to leave it there, based on the other options available to me. Other potential investments are competing for those funds, so they are still a player in the (dynamic, not static) economy, even though they are owned outright.

No, what I'm describing is a process by which capital enters the market without the need to print more money, or, in the case of a gold standard, without unnecessarily increasing the value of the backing commodity above its market value to allow a greater amount of financial capital to exist under a stable amount of currency.

I agree that more money doesn't need to be printed to create new capital. In the normal circumstance where newly created capital has more value than the money it took to create it, I don't see how that could fail to increase the value of money, given a constant supply. However, that increased value is still the market value. Is that what you mean?

In a free banking system the depositors and banks would weigh the risks involved in fractional reserves with the benefits of drawing interest. With the fraction at 100%, there is no interest and no risk.

What about time deposits? It's possible to have a 100% reserve, where current account depositors pay a regular "management" fee, and interest is only paid on time deposits.

Without fiat currency and a nanny state insuring depositors, FRB acts efficiently to optimize the production and growth of the economy, and the fraction reflects an acceptable risk-adjusted return on depositors investments.

What about people who don't keep their money in banks? FRB devalues their holdings, without their consent. Wage earners or those on fixed incomes are similarly damaged. That is not a free market.

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Stuff from the 26th:

My first objection to FRB is a moral one.

That's fine, Ace, but there's no need to stress this one too much. There's certainly no need to lob accusations at anyone, not even the banks themselves. Well, maybe a few academics deserve a pasting, but that's beside the point. The moral question is only icing on the cake, so to speak, identifiable only after the technical detail has been explained. In practice it wont do much except convert negligible presence of FRB to non-existent. The bulk of the issue is practicality.

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

Sorry, that's not true. When gold is money, fractional reserve banking means having less gold in reserve than the total amount of customer accounts that could be withdrawn or have cheques drawn against at a moment's notice. There's nothing that says this inherently can't happen under laissez-faire with a proper gold coin standard.

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.

The first sentence is completely false, and while the second sentence is technically true it misses the point. The first is incorrect because FRB reduces the value of every single unit of the medium of exchange. What the second misses is the upshot of this, because this reduction is of both paper and gold coin, equally. Thus there is no incentive to cash in the paper for coin unless the paper's issuer had its liquidity questioned, and in that sense sentence 2 is correct.

The correctness of sentence 2 misses the point (and admittedly it's a minorish point) because what gets devalued is not "gold" per se but gold in a particular form, namely in coins, relative to gold in other forms. The devaluation of gold coins while the amount of money in total is still going up makes other uses of gold less expensive, such as jewellery. So, one consequence of FRB is indeed the melting of some coins and converting the gold to another form - but not because of any mismatch in the value of paper money versus gold coins as there will be no such mismatch. I doubt that it's a major effect, but it is there.

Doesn't this lend itself to support the case that under a truly free laissez-faire economy, 100% reserve ratios would be chosen by the markets?If it was government socialization of credit which caused reserve ratios to fall to 5%, then why wasn't it government socialization of credit which caused reserve ratios to fall to 42%?

That was what the question of the 19th century was about. The case you mention presumes that everyone in the economy knows the full details of the principles involved and that this knowledge is required in order to succeed. This is one of the things I disputed with GB over. My argument was that businessmen were ignorant of the principle involved, and had to be because key economic ideas hadn't been properly developed yet, but that this didn't stop them from being highly productive because it was a deeper issue with diffuse effects and whose implications did not need to be known to succeed in business. It's like a rally car driver not having to know the exact chemical composition of a particular brake fluid to win any given race, even though over the longer run it might be slowly eating some hoses more than usual. This makes his maintenance costs slightly higher than they would be if he bit the bullet and stumped up for a more expensive fluid. He can happily go on winning lots of races without making the slightest connection between that particular fluid and the increased rate of hose replacements because hoses get replaced all the time anyway. The only people who might take even an interest in the matter are the extreme-cutting-edge racing teams in Indy or F1 spending umpteen times as much money as a rally team.

GB is quite right to say that there's a lot of explaining to do there and that the data suggests not accepting attacks on FRB unless there are good grounds for saying there's something wrong with it. That is what I am saying, and I've given the basis of that explaining, but doing it justice is a lot of work. I've also pointed out the core point of why there's something wrong with FRB (the bit about people's physical expectations being unchanged) and why this didn't affect the success of 19th century businessmen. I do recognise that there's a lot of difficulty with understanding what the expectations bit actually means and how it works in practice - the whole FRB argument has arisen also on HBL and I don't foresee it being resolved in a hurry there, either.

The main reason is that it economizes the supply of costly-to-store and maintain specie.

And that one I showed was a fallacy. Exactly the same amount of gold is going to go back into bank vaults and tills as reserves, irrespective of whether they back 1x, 2.38x, or 20x in accounts. That means there will be exactly the same costs for storage and security of specie with or without fractional banking. Nothing is economised.

JJM

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The bulk of the issue is practicality.

Whether it's practical or not doesn't matter if it's not moral.

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

Sorry, that's not true. When gold is money, fractional reserve banking means having less gold in reserve than the total amount of customer accounts that could be withdrawn or have cheques drawn against at a moment's notice. There's nothing that says this inherently can't happen under laissez-faire with a proper gold coin standard.

What I meant by a "true gold standard" is that all money in circulation can be redeemed for gold at any time. Since fractional reserve banking creates new money through bookkeeping entries, it cannot exist under that definition. And what is a bookkeeping entry if not "fiat"?

Your definition of a "proper gold standard" is really a fractional gold standard, where only some of the money in circulation can be fully redeemed for gold. To me, that's not a gold standard at all. What are the reasons for adopting a gold standard in the first place? Eliminating inflation should be at the top of the list -- which includes the ability of government or banks to debase the currency and for them to steal from net savers. A fractional gold standard doesn't accomplish that.

There isn't really a fundamental difference between fractionally-backed money and fiat money, since both can be created in indefinite amounts. You might argue that on a fractional gold standard, at some point there would be market push-back, where people would exchange their currency for gold if it got too diluted by fractional lending or other forms of money creation. That's basically what happened in 1933, when FDR was forced to devalue the dollar against gold, and again in 1971 when Nixon was forced to abandon Bretton-Woods -- it results in a crisis as reserves are withdrawn from the banking system, and it's not conducive to long-term market stability.

Edited by AceNZ
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I think this discussion would help from some definitions and proper understanding of key concepts.

Inflation -- Inflation is not just any increase in money, regardless of cause. If the increase arises from voluntary market interactions, it is not inflation. So, the discovery of more gold, or an increase in lending by a bank is not inflation. Rather, inflation is an increase in money by government, or induced by government. It is an increase that is not tied to reality. It is artificial, arbitrary and subjective. To the extent it exists, it does represent an unfair theft of the value of everyone's money.

(This idea became clear to me from a comment by Harry Binswanger posted on today's HB list [subscription required @ hblist.com].)

The financial impact, a generalized increase in prices, can be the same from a huge discovery of gold as it would from a doubling of the money supply by the Federal Reserve, but at their root, these are two different phenomena. The discovery of gold is an objective fact of reality, and must be accepted. The increase of money by the Fed is an artificial, man-made phenomenon that need not be tolerated. On the contrary, it should be opposed and stopped. You can't stop the discovery of gold; it exists. It is objective. You can stop man-made manipulations of money, and should.

These are related concepts, but they are different and require two different words to describe. One word, inflation, cannot be used for both. I would simply call the first case a market-driven increase in the supply of money. The second case is inflation.

Using this definition, fractional reserve banking is not inflationary. Only when there is also a central bank is it inflationary. Historical evidence backs up this view. The socialization of credit beginning during the Civil War and the establishment of the central bank in 1913 led to a progressive reduction in the average reserve percentage in the economy (from the low 40% range to less than 5% today). It also led to a generalized increase in prices and destruction of money's purchasing power, beginning in the 20th century.

Central banks are the problem, not the private, voluntary banking practices that arise in the market.

*******

A related concept also requires some clarification. I have heard many times that fractional reserve banking is immoral because it reduces the value of other people's money. First, in the absence of a central bank, that is not true. As I described, the overall reserve percentage in the economy was stable when there was no central bank, and it only began to decline when credit became socialized and a central bank was established. Moreover, the value of money actually rose during this period, as it did nearly continuously during the 19th century, a period dominated by fractional banking, but without a central bank.

However, even if fractional reserve banking did cause the value of money to fall, it would still not represent stealing. It is no more stealing than if a new product introduced by an entrepreneur reduces the value of something I own. For example, let's say I own a beautiful carriage and some healthy horses that I use to drive around town in. The entire set-up is worth $5,000. Now, Henry Ford comes along and invents the Model T and sells it for $100. Very quickly, as I trot around town in my horses, I begin to see cars everywhere. Next thing, when I try to sell my horse and buggy, I find that I am only offered $50 for it. Did Henry Ford steal $4,950 from me? Of course not.

No one has the right to a certain market value for the goods they own, whether those goods are gold coins, dollar bills or horses-and-buggies. All values must be earned and fought-for in the marketplace. As long as physical force was not used to harm my possessions, any diminution in value that occurs due to market forces is mine alone to bear.

So, no one has a right to a particular value for their money. The value of their money will be determined by the interaction of many market players -- gold miners, bankers, businesspeople, etc. Someone only has the right that the banks with whom they do business do not commit fraud. Honestly disclosed banking practices, whether of fractional or full reserve variety, are not fraudulent. There is nothing at all immoral with fractional reserve banking in a laissez-faire context.

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You're basing your argument, then, on two premises:

First, that risk-adjusted ROI for a given piece of capital used in a given capacity is identical for the outright buyer and for the borrowing buyer.

Second, that the amount of real capital in an economy does not increase over time.

I'm neither claiming nor depending on either.

For the first, I am saying that:

1. the new credit generated by the banks competes with existing credit, and so initially drives down the cost of credit

2. the new competitor getting the cheaper loan can achieve a higher ROI than the existing competitors still paying interest at the older higher rates, so the new will start to squeeze out the old before the old can start getting credit at the new lower rates

3. this ripples out eventually to the entire economy, affecting everyone providing credit and using credit (*)

4. the people providing the funding by which all this physical capital is continually renewed start withdrawing their funding, because the returns aren't good enough anymore, and also borrow to spend on consumer goods instead of investment because it's become cheaper to get into consumer debt

5. this withdrawal of funding pulls up the cost of credit back to where it was because the original creditors' requirements haven't changed

6. the rising cost of credit and the rising cost of resources being competed away for making consumer goods then pulls down the ROI of all borrowers

7. the competing away of material resources and the pulling down of ROI slows, then halts, then reverses physical investment, stopping when the ROI all around for each position on the risk-reward spectrum is back up to where it was before, in line with 5.

8. this may bounce around for a while, up and down a few times, but eventually resting as per 5. In the mean time, some resources are wasted, especially physical energy and people's time

(*) Technically, it's all providers and users of all types pf capital funding, not just credit. In the $2000 to $2500 example, the $2500 new nominal might be worth anywhere between say $1800 or $2200 of the old nominal, where the difference from $2000 will go to or come from values of equity. That's really technical stuff I was trying to avoid raising, but since you've mentioned all of capital funding and the whole risk-reward spectrum, it's only fair.

For the second, I am saying that FRB exclusively as a factor on its own does not lead to new capital that lasts. The long-term growth in capital follows its own path, and is not improved any by the use of FRB.

If technology, population and etc were constant, the only thing that would lead to a permanent increase in capital is if people's requirements for ROI fell. If it did, they'd make that felt through how they save and invest financially. At the start when expectations first change, the existing physical capital provides an ROI that matches the old minimum expectation but is now more than the new expectation. In finance, that ROI corresponds to a certain rate of interest (and profit, but ignore that), so because the rates are now above people's new minimums they will save more. That extra saving means more funding, which lets businesses invest more. The more physical investment then causes the actual ROI achieved to fall because of increased competition and other causes. At the same time, the rates of interest keep on falling, too. Capital keeps getting saved and invested until the ROI and rates of interest both drop to meet people's minimum expectations. When that happens, there will be more total outstanding credit and also more physical capital, a new relationships between ROI and interest will be established. The new bigger totals are solid, because that's the amount that corresponds to people's expectations about ROI and interest.

FRB does not assist this or any other growth process in any way. All it does is muck up the connection between the physical ROI and interest on savings and making the two frequently overshoot and undershoot each other back and forth for a while as per #8 above.

The current FRB fraction is far less than it would be without the moral hazard created by the Fed insuring banks with fiat currency.

That was never in question. The only issue is whether a little bit is good or none is good, in the context of free banking. Others say it's not a problem if the government's not involved, while I am saying it's only less of a problem if government's not involved.

If the bank cannot lend deposits out, what is its source of income? I believe you would have to pay it money

Paying the bank money to store your gold etc is indeed one way (and historically was the original way) in which banks can earn money, just like people paying fees to park their cars in garages or hold goods in lock-ups. That's not a problem. The real issue is about how lending is accomplished at all. I answered that by showing different types of accounts and financial products that both banks and non-bank institutions offer. For instance, Ace mentioned time deposits, which down here I know as term deposits. Whatever the product is, they borrow money from you or sell you investment products, they pool it and invest it in their nice efficient way, make interest, pay you some, and keep the difference (which they have justly earned). What makes them non-fractional is the way the bank lets you treat the money that paid for them.

In order to get your money back, you would have to sell your shares. Now this is what *actually* is going on with a savings account (My credit union refers to shares and dividends in its statement), which is why I don't really have a beef with FRB.

Ah, but the problem is that this isn't what is actually what is going on. What's happening with FRB is that they are borrowing from you (no problem there), but then letting you still treat the money in your account as though they hadn't borrowed from you. That is, you can still write cheques or go online and do direct deposits, even though the bank or credit union has lent it out. This makes money look like it's in several places at once and able to be spent simultaneously in more than one location. That's what the talk of the multiplier is about.

Your shares and units idea would work, and yes it wouldn't be FRB so the problem would go away, but something that complicated isn't necessary. All that the banking system needs is for money in accounts that can be used without notice to have every dollar's worth of money physically sitting in reserve. The same physical quantity of money is always going to be sitting there anyway, so that's not the issue. The problem is the money double-act doing bad things to the lending. If the banks want to borrow from that pile of money so they can lend it to others then that's fine on its own, but it's not a good idea for banks to do so and then let people still act as though there had been no borrowing from the pile. It's this allowance that converts what would be perfectly healthy lending and borrowing into something potentially destructive.

JJM

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QUOTE (Galileo Blogs @ Mar 26 2008, 09:36 PM) *

"The main reason is that [maintaining a fractional reserve] economizes the supply of costly-to-store and maintain specie."

And that one I showed was a fallacy. Exactly the same amount of gold is going to go back into bank vaults and tills as reserves, irrespective of whether they back 1x, 2.38x, or 20x in accounts. That means there will be exactly the same costs for storage and security of specie with or without fractional banking. Nothing is economised.

Yes, the cost of storing the specie is the same, except that by only maintaining fractional reserves, a greater amount of lending can occur for a given quantity of specie. The bank makes more money. Another way to look at it is that for a given quantity of revenue-making loans, a smaller quantity of specie is needed to be maintained in the bank's vaults as a reserve.

Therefore, it is undoubtedly more economical to maintain fractional reserves. If it weren't, then full-reserve banks would have a competitive advantage over fractional reserve banks and would out-compete them. That did not happen.

Fractional reserves allow banks to perform their intermediation function at lower costs by economizing their reserves.

By the way, this is where the insurance analogy is useful. Yes, banks and insurers are different, but both are similar in having to figure out how to make the most profits while preserving their ability to pay out their financial obligations. Participants in both industries have figured out how to do this while economizing on costly reserves.

I can extend this analogy further to inventory management in general. Banks must maintain their inventory of reserves just as stores must maintain their inventory of goods to be sold. It is amazing how a supermarket virtually never runs out of key items, even though they never know with 100% certainty how many people will buy, for example, cat food on a particular day. Banks maintain their inventory of reserves in the same manner. In all industries, inventories are costly to maintain, and that is why merchants (including banks) seek to meet their obligations while maintaining the smallest possible inventories.

To do this, stores constantly innovate to develop methods to manage their inventories more effectively. Stores locate warehouses near the stores, they come up with just-in-time inventory methods, etc. By the same token, banks innovate by maintaining high reserve levels (42% in the free banking era), but also by developing clearinghouses that allow banks to loan each other reserves. Moreover, investors in banks regularly evaulate the banks' published financial results, and bid their stocks and bonds up or down. That provides signals to the market about the financial health of the banks.

Moreover, there is the phenomenon of adverse clearing that serves as a check on the issuance of notes. If a bank over-issues notes, those notes will trade at a larger discount, and people will be encouraged to present them to the bank for conversion into gold. Thus, convertibility serves as a check on the over-issuance of notes.

Moreover, there are laws against fraud, which serve to minimize bank frauds.

All of these practices were actually implemented in the 19th century, and it worked rather well. It is important to ground a discussion of this kind in facts. Fractional reserve banking not only makes sense in theory, but in practice it worked quite well. In particular, the argument that it somehow debases the value of money is completely belied by the general rise in the value of money that occurred during most of the 19th century. With such a pesky fact, could it be that the theoretical argument that fractional reserve banking causes inflation is perhaps wrong?

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The first sentence is completely false, and while the second sentence is technically true it misses the point. The first is incorrect because FRB reduces the value of every single unit of the medium of exchange. What the second misses is the upshot of this, because this reduction is of both paper and gold coin, equally.

You are still confusing changes in M with changes in P.

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Inflation -- Inflation is not just any increase in money, regardless of cause. If the increase arises from voluntary market interactions, it is not inflation. So, the discovery of more gold, or an increase in lending by a bank is not inflation. Rather, inflation is an increase in money by government, or induced by government. It is an increase that is not tied to reality. It is artificial, arbitrary and subjective. To the extent it exists, it does represent an unfair theft of the value of everyone's money.

Inflation, according to Mises at least, is defined as an increase in the money supply. The source of that increase is secondary.

The discovery of a lot of gold is inflationary. More gold competing for the same products would cause prices to go up as the value of money went down. Bank lending is also inflationary, for the same reason. The underlying mechanisms of inflation for governments, banks and gold discoveries might be different, but the net economic effect is the same.

These are related concepts, but they are different and require two different words to describe. One word, inflation, cannot be used for both. I would simply call the first case a market-driven increase in the supply of money. The second case is inflation.

The same word is used for different, but related, concepts all the time.

Central banks are the problem, not the private, voluntary banking practices that arise in the market.

How about if the equivalent of a central bank were to arise in the market? A large bank voluntarily gets together with other banks and agrees to share reserves. Wouldn't that be a "voluntary banking practice"?

However, even if fractional reserve banking did cause the value of money to fall, it would still not represent stealing. It is no more stealing than if a new product introduced by an entrepreneur reduces the value of something I own. For example, let's say I own a beautiful carriage and some healthy horses that I use to drive around town in. The entire set-up is worth $5,000. Now, Henry Ford comes along and invents the Model T and sells it for $100. Very quickly, as I trot around town in my horses, I begin to see cars everywhere. Next thing, when I try to sell my horse and buggy, I find that I am only offered $50 for it. Did Henry Ford steal $4,950 from me? Of course not.

I'm not saying that people have a right to a constant value of money. The purchasing power of money, like with any other medium of exchange or commodity, can and does vary with the free market.

The moral flaw with FRB stems from the fact that it allows something to be created from nothing. It is that aspect that differentiates FRB from the basic free market, and theft is the end result.

How is FRB fundamentally different from counterfeiting? Let's say I open two businesses. In the first one, I accept deposits. I pay interest to depositors and pledge to store their funds securely. In the other one, I print very high-quality counterfeit money. I offer to exchange the money for a promise to repay (a loan), if the borrower agrees to pay a fee (interest). Most people would agree that the actions of the second company are criminal. After all, the money isn't "real". And yet, when the two companies are combined, that is exactly what FRB allows -- only the money that it creates is checkbook money rather than actual notes. Establishing some artificial connection between the deposited funds and the newly created money ("reserves") doesn't make the counterfeiting any less criminal.

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In particular, the argument that it somehow debases the value of money is completely belied by the general rise in the value of money that occurred during most of the 19th century. With such a pesky fact, could it be that the theoretical argument that fractional reserve banking causes inflation is perhaps wrong?

It's possible for the value of money to decrease in the presence of inflation. Monetary inflation and price inflation are two different things.

Something similar to the 19th century happened in the 1920's, prior to the stock market crash. The money supply was being inflated tremendously, and yet prices fell. Japan in the 1990's is another example.

Factors in addition to the money supply, such as the demand for money, cash hoarding, import/export balance, general improvements in production, etc, also influence prices.

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Inflation, according to Mises at least, is defined as an increase in the money supply. The source of that increase is secondary.

The discovery of a lot of gold is inflationary. More gold competing for the same products would cause prices to go up as the value of money went down. Bank lending is also inflationary, for the same reason. The underlying mechanisms of inflation for governments, banks and gold discoveries might be different, but the net economic effect is the same.

The same word is used for different, but related, concepts all the time.

How about if the equivalent of a central bank were to arise in the market? A large bank voluntarily gets together with other banks and agrees to share reserves. Wouldn't that be a "voluntary banking practice"?

I'm not saying that people have a right to a constant value of money. The purchasing power of money, like with any other medium of exchange or commodity, can and does vary with the free market.

The moral flaw with FRB stems from the fact that it allows something to be created from nothing. It is that aspect that differentiates FRB from the basic free market, and theft is the end result.

How is FRB fundamentally different from counterfeiting? Let's say I open two businesses. In the first one, I accept deposits. I pay interest to depositors and pledge to store their funds securely. In the other one, I print very high-quality counterfeit money. I offer to exchange the money for a promise to repay (a loan), if the borrower agrees to pay a fee (interest). Most people would agree that the actions of the second company are criminal. After all, the money isn't "real". And yet, when the two companies are combined, that is exactly what FRB allows -- only the money that it creates is checkbook money rather than actual notes. Establishing some artificial connection between the deposited funds and the newly created money ("reserves") doesn't make the counterfeiting any less criminal.

The reason for distinguishing between types of inflation is to highlight that market-caused "inflation" such as the discovery of more gold is not a cause for concern, but if government has the ability to inflate, it is a serious cause for concern. The latter should be legally forbidden while nothing can or should be done about the former, apart from market participants themselves responding to it.

As for issuing notes backed by fractional reserves being fraudulent or a form of counterfeiting, it clearly is not if it is fully disclosed to the bank's customers.

Edited by Galileo Blogs
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As for issuing notes backed by fractional reserves being fraudulent or a form of counterfeiting, it clearly is not if that is fully disclosed to the bank's customers.

So if the counterfeiter in my example told his customers that he was giving them perfect-looking, undetectable counterfeit money, then it would be acceptable?

Imagine a music producer. He spends a lot of time, money and effort to find a good band, get studio time and do the other tasks needed to create a top-selling CD. The resulting recording has value; he is able to selling copies of it in the free market for a price that allows him to recoup his investment and make a profit. He expects the price he can get for his work to fluctuate in the free market. Now someone comes along who makes copies of his recording without his permission and either gives them away or sells them at a low price -- he even tells people that he is providing unauthorized copies. The result is that the music producer is not able to sell as many copies as he could before and that the price he can obtain has declined. The overall value of his work is lower. He has been deprived of that value against his will by fraudulent means. Has a crime has been committed against him? Of course it has.

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I'm neither claiming nor depending on either.

For the first, I am saying that:

1. the new credit generated by the banks competes with existing credit, and so initially drives down the cost of credit

2. the new competitor getting the cheaper loan can achieve a higher ROI than the existing competitors still paying interest at the older higher rates, so the new will start to squeeze out the old before the old can start getting credit at the new lower rates

3. this ripples out eventually to the entire economy, affecting everyone providing credit and using credit (*)

4. the people providing the funding by which all this physical capital is continually renewed start withdrawing their funding, because the returns aren't good enough anymore, and also borrow to spend on consumer goods instead of investment because it's become cheaper to get into consumer debt

5. this withdrawal of funding pulls up the cost of credit back to where it was because the original creditors' requirements haven't changed

6. the rising cost of credit and the rising cost of resources being competed away for making consumer goods then pulls down the ROI of all borrowers

7. the competing away of material resources and the pulling down of ROI slows, then halts, then reverses physical investment, stopping when the ROI all around for each position on the risk-reward spectrum is back up to where it was before, in line with 5.

8. this may bounce around for a while, up and down a few times, but eventually resting as per 5. In the mean time, some resources are wasted, especially physical energy and people's time

What you're describing here is the "step response" of an economy to the introduction of FRB.

However, your analysis is flawed at step 4 - which people start withdrawing their funds, the bank depositors that allowed a lower interest rate on loans, or the lenders whose money is tied up in individual pieces of capital and not diversified across a broad field of capital? I know the answer, just seeing if you're going to say that lowering the cost of getting loans is a bad thing or a good thing, assuming the risk passed on to the lenders is also reduced.

At step 5, you forget that the original creditors, the ones who didn't have FRB to handle their loans, and therefore had to loan to individual borrowers, are the ones who have been driven out, because borrowers can now share their individual risk with all other borrowers, lowering the resultant risk to lenders, and thereby lowering the interest required for any one loan. The ROI requirements may not have changed, but ROI is always accounted as risk-adjusted return, with negative risk being counted much higher than positive return. As a concrete demonstration of the effects of that, consider two types of loans, one of which has a 10% probability of complete loss, the other has a 0.1% probability. A math analysis would posit that the one with 10% probability would require 11.2% higher interest than the 0.1% loan. The truth is that 10% probability of total loss, for a single investor would require much more than 11.2%, because the downside, of a 10% chance of losing all your money, is counted as much greater than the upside a 90% of getting 11.1% return (although in the long run or broad spread, the two returns are equivalent). The decrease in cost of borrowing and in risk of loaning afforded by FRB will drive other forms of lending out.

So step 6, the cost of borrowing doesn't adjust up and down, except as the amount of reserves rises and falls, changing the risk and requiring changes in returns. The increased return requirement of lower reserves drives out borrowers, and naturally adjusts the reserves up.

Step 7, your risk has gone down, your reward has gone down, so your overall ROI is, as you correctly state, back where you started. But things are different now.

Step 8, with a finer tuning on risks and rewards, you find that investors are able to evaluate more accurately the best investments, and resources that used to be wasted due to the noise involved in person to person loans, has abated, allowing a more efficient allocation of resources.

We can continue to disagree on this, but, unless you favor outlawing FRB, or even regulating its use, this discussion is academic. Hopefully before either of us passes on to that great safe deposit box in the sky, we will experience a free market economy. I've got a cold pint of Cooper's says FRB will still be around.

Edited by agrippa1
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So if the counterfeiter in my example told his customers that he was giving them perfect-looking, undetectable counterfeit money, then it would be acceptable?

I am sorry AceNZ, but that is not what we are talking about here. All bills would bear the mark of the issuing bank. If a bank issues bills stamped "Galileo Blogs' FRB Notes," it would be clear what they are. All participants in the economy are free to accept those bills or not, or they could choose to accept the bills stamped "AceNZ 100% Reserve Bank Notes" instead. My bank's issuance of bills is my business and my customers' business, and in no way illegally affects your customers' acceptance of your bills.

Of course, if I deliberately counterfeited bills to look like your bank's bills, that would be wrong. But that is certainly not what we are discussing here, at least as far as I am concerned.

To get back to the real world examples I like to cite, during the free banking era, all bills bore the names of the private banks that issued them. Currencies competed for customers. Naturally, customers exerted great effort to select currencies issued by sound banks. That competition for customers also caused banks to maintain adequate reserves to be able to convert notes that were presented upon demand into gold. There was no promise to maintain 100% reserve backing of those notes, only a promise to convert them upon demand into gold. That did not require that 100% reserves had to be kept at the bank, any more than a supermarket needs an entire warehouse full of cat food to meet the needs of each day's customers who demand cat food (to extend my prior analogy). Instead of an entire warehouse full of cat food, the supermarket only needs to keep enough cat food in reserve in the back of the store to meet the expected day's purchases, with allowance for days when there are unusually large purchases.

Likewise, a fractional reserve bank must balance the opportunity to gain immediate profits that comes from loaning out reserves with the long-term solvency and financial success that comes from maintaining an adequate level of reserves. As I mentioned, during the free banking era the percentage of reserves that balanced those two goals was rather high, in the low 40% range.

Edited by Galileo Blogs
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Yes, the cost of storing the specie is the same, except that by only maintaining fractional reserves, a greater amount of lending can occur for a given quantity of specie. The bank makes more money. Another way to look at it is that for a given quantity of revenue-making loans, a smaller quantity of specie is needed to be maintained in the bank's vaults as a reserve. Therefore, it is undoubtedly more economical to maintain fractional reserves.

You're assuming that the increase in the nominal amount of outstanding loans always means a lasting increase in total real capital formation. I have said repeatedly that this assumption is dead wrong. The determinants of total real capital are time-preference plus risk-reward profiles, acting in conjunction with other physical considerations (eg demographics, technology). FRB does not change those determinants for the better: it cannot change the physical considerations, it does not lower people's time preference, it's existence is not necessary to make more risk-pooling and scale-efficiencies than would otherwise exist, and if anything it will hinder capital formation because it actually increases risk and its associated costs. Therefore, it is undoubtedly uneconomical to maintain only fractional reserves because the same specie handling costs are being divided among the same or less total real capital while also therefore pointlessly making the financial sector more shaky.

Abstracting from all the other physical factors that lead to a given total amount of real physical capital, that total amount stands independent of the total nominal dollars in which the debt and equity funding it are counted. It is only changes in the nominal figures that lead to changes in the real amounts because people treat the financial numbers as representative of the realities. However, this is because people have gotten use to the existing relationship linking the financial numbers and the physical reality and will presume that it hasn't changed unless there's reason to think it has. The introduction of FRB only causes a change in that link, temporarily increasing real capital until people realise what has happened to that link. Once they do, then they reassert their original and unchanged real preferences through the new financial numbers by readjusting their numerical expectations to fit the new link, dragging real capital back to where it was before or worse plus generating increased on-going monitoring costs. This is why I have said that FRB only obfuscates and rubberises that link, and contributes nothing except confusion and waste.

All that the reference to the 19th century does is show that back then the confusion and waste were either unidentified or were low enough to be considered not worth making an effort to deal with (as everyone points out, interest on accounts offsets account-keeping fees). I've been trying to find the case in England (18th or 19th century) where someone did try to make the effort but got busted down by the court - that was the failure I mentioned. It was that case that formally cemented the legal status of the depositor-bank relationship as credit rather bailment, making futile any attempt thereafter to try to have full-reserve accounts. I'll continue looking for it, and I'll post the citation when I find it.

If it weren't, then full-reserve banks would have a competitive advantage over fractional reserve banks and would out-compete them. That did not happen.

You're assuming perfect (or at least good enough) knowledge on the part of the customers, or that they cared enough to change banks to get full-reserve accounts. We've disputed the first part of that before, and I still stand by what I have written on the matter.

With such a pesky fact, could it be that the theoretical argument that fractional reserve banking causes inflation is perhaps wrong?

Never once have I questioned that fact, and I don't consider it remotely pesky. All I have said was that in the future, people armed with better knowledge of causes and consequences wont be so forgiving. As to inflation, I don't start with the assumption that FRB is inflation and then say therefore FRB is bad, but instead show how FRB is bad and identify therefore that the credit multiplication should also be included within the meaning of inflation. People are too hung up about bad government to see other non-government sources of inflation, though I disagree with Ace's idea about more gold itself being inflationary. My arguments on this are what set this whole thread off to start with, btw.

JJM

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However, your analysis is flawed at step 4 - which people start withdrawing their funds, the bank depositors that allowed a lower interest rate on loans, or the lenders whose money is tied up in individual pieces of capital and not diversified across a broad field of capital? I know the answer, just seeing if you're going to say that lowering the cost of getting loans is a bad thing or a good thing, assuming the risk passed on to the lenders is also reduced.

The first people to withdraw money aren't the account holders, because their motivation to keep money in the bank is driven by the demand for ready money plus the convenience of having cheque books etc. For them, the interest earned is just something that helps them decide which bank to trade with.

Instead, the first people to withdraw funding, or rather to fail to renew funding, are those investing in "money-market" instruments, such as overnight loans and short-dated bills, because the rates in the primary markets are the most variable there. From there, bit by bit, it moves up the chain of greater and greater maturities as all the individual loans in them mature and the funds made liquid again ready to be reinvested at new rates, or not invested at all. It's important not to get side-tracked by the secondary market in them, the real movement of concern is in the primary market for renewals upon maturity, each maturity range roughly corresponding to the life-span of the physical capital involved.

And, I am not saying either way whether it's a good thing or a bad thing as an absolute, I am only noting that the market rates have been pushed lower by FRB than where people in aggregate want them to be. I do recognise that in the construction of that aggregate there is a range of people with different minimum expectations. This is the nub of my rejection of your claim that I was assuming people had equal ROI requirements. As market rates get pushed down, it's those with the highest expectations who start pulling out first. That leaves behind those with lower requirements, but the total amount of funding they contribute isn't enough to maintain the now-higher level of physical capital that needs to have its funding constantly renewed.

...lowering the resultant risk to lenders, and thereby lowering the interest required for any one loan. The ROI requirements may not have changed, but ROI is always accounted as risk-adjusted return, with negative risk being counted much higher than positive return.

Two things. First, you're assuming that only FRB makes risk-pooling possible, which I dispute. This is why I said the technical detail of how lending would still be accomplished was the last major detail. The efficiencies of scale will still be there and operating to full effect, even without FRB, in the manner I've already described. Thus FRB doesn't lower risk any more than it already will be without FRB, because there's already going to be the full complement of risk-transformation and diversification practices as required.

Second, you're forgetting that the existence of the credit multiplier increases the exposure of all loans to the vicissitudes of not just Aunt Clara's craziness but anything whatever that makes people want to withdraw cash from their accounts to hold in person. If there's a bit more withdrawal of cash than expected then the bankers will have to change their lending plans (which costs time and money to do), including possibly selling bits of their loan portfolio at prices lower than they're happy with. Again as I said it's not a major thing in most cases, but that increase in riskiness is there. It was those very risks that caused people to discount the notes they received in the 19th century.

So, with diversification not appreciably increased, and the total money supply being more unpredictably variable, the total risk has gone up rather than down. That means people's minimum ROI's will go up. On top of that, the variability of the money supply causes a need for increased monitoring costs, so that makes it harder for those ROI's physically to be met. The only way the two can be brought into alignment, on the assumption of other physical factors being unchanged (demographics, technology, the state of mines and agriculture, and so on), is for the total real capital to fall. That fall in capital then allows the ROI on the remainder to go up because of reduced competition for limited resources (especially labour). Therefore, FRB causes total real capital maintained to be less than it would be had there been no FRB.

We can continue to disagree on this, but, unless you favor outlawing FRB, or even regulating its use, this discussion is academic. Hopefully before either of us passes on to that great safe deposit box in the sky, we will experience a free market economy. I've got a cold pint of Cooper's says FRB will still be around.

I don't see it as academic, but nor do I see it as it being end-of-the-world if people don't understand. I just see failure to understand as a minor chink in the armour, a little hole in the provision of what completes the case for man's rights. The general making of the case is still there, untouched, irrespective of this little detail about FRB. The only problem with the hole is if people don't accept that case then the continued existence of FRB made possible by that hole makes it easier for non-LFC people to implement their plans before we have the chance to put a halt to it by making the case to people.

As to disagreement, at least you correctly recognised the centrality of the time-preference & risk-reward factors and then tried to deal with them, even if I do disagree with your assessment. I'd shout you a Coopers any time.

JJM

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