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Fractional Reserve Banking versus Ayn Rand's Ethics

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Paul McKeever

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VIDEO TITLE: Gold, Inflation, Fractional Reserve Banking, and Ayn Rand's Ethics

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DESCRIPTION: A response to those who think the ethics of Ayn Rand's philosophy, Objectivism, is consistent with fractional reserve banking.

In the first part of this video, Paul McKeever gives the general history of how gold came to be money, how banks came into being, how banks started to lend on a fractional reserve, how and why central banks were formed, and how gold was replaced with paper. In the second part, Paul explains the true nature of inflation, and exactly what it was that Ayn Rand found to be ethically wrong about it.

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DESCRIPTION: A response to those who think the ethics of Ayn Rand's philosophy, Objectivism, is consistent with fractional reserve banking.

Interesting :)

I have tended to think that fractional reserve wasn't inconsistent with Objectivism, particularly if the parties involved understand the risks and when it's not commandeered by the government.

You are saying fractional reserve banking is unethical even if the government weren't involved?

I like what you've done on YouTube. Thanks, I'll have to watch the video(s) again - it's not overly complicated, but it's a lot to process!

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I have tended to think that fractional reserve wasn't inconsistent with Objectivism, particularly if the parties involved understand the risks and when it's not commandeered by the government.

Everything I've seen would tend to agree with this.

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McKeever has convinced me. Fractional reserve banking is also unethical because there is always, eventually, a run on the bank. Right now the global credit crunch is an instance of banks running on each other. One would think that banks as institutions would know not do that to each other, but it appears that one would be wrong. Because they always end badly, pyramid schemes and fractional reserve banking should both be outlawed.

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McKeever has convinced me. Fractional reserve banking is also unethical because there is always, eventually, a run on the bank. Right now the global credit crunch is an instance of banks running on each other. One would think that banks as institutions would know not do that to each other, but it appears that one would be wrong. Because they always end badly, pyramid schemes and fractional reserve banking should both be outlawed.

All bank balance sheets are inherently runable, regardless of whether time deposits are involved. This most recent crisis had nothing to do with time deposits, and yet the potential to create a panic still exists. You don't resolve that by going to 100% reserves. IN a class at OCON 06 (dont'remember which) I remember the discussion coming up and the general though of the instructor is that you let banks decide. Some will got o 100% and some might not, but the idea that 100% suddenly provides intrinsic safety is a poor one.

One can and should make the case that the level of fractional reserves shouldn't be arbitrarily set by fiat, but that is certainly not the same thing as calling them immoral, per se.

Paul doesn't seem to understand this. btw I tried to listen to the vid, but the incredibly distracting effect of delivering a lecture while driving a car was more than I was willing to stomach. Yes, Paul, you can give a lecture while driving, spinning plates, and rubbing your stomach in a circle....

Edited by KendallJ
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Fractional reserve banking is also unethical because there is always, eventually, a run on the bank... Because they always end badly, pyramid schemes and fractional reserve banking should both be outlawed.
I have a question.

In the case of a run on the bank, the balance holder isn't wronged assuming he knew the risks involved.

Outlawing fractional reserve banking because the populace is now affected by bank-caused inflation seems (to me) like a questionable reason to outlaw it. Suppose I start using IOUs as money and some merchants accept them. If my actions shouldn't be outlawed, what is the difference between what I have done and what fractional resereve banks have done?

btw I tried to listen to the vid, but the incredibly distracting effect of delivering a lecture while driving a car was more than I was willing to stomach.
It was... different :) The length of the video got to me more than the driving. I give him points for creating it and getting a discussion going though.
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I have a question.

In the case of a run on the bank, the balance holder isn't wronged assuming he knew the risks involved.

Outlawing fractional reserve banking because the populace is now affected by bank-caused inflation seems (to me) like a questionable reason to outlaw it. Suppose I start using IOUs as money and some merchants accept them. If my actions shouldn't be outlawed, what is the difference between what I have done and what fractional resereve banks have done?

But if your actions result in a theft, they already are outlawed. That there is no difference between writing bad checks and fractional reserve banking is the point.

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That there is no difference between writing bad checks and fractional reserve banking is the point.

There is if you gave the bank your money knowing that those were the terms. That's hunterrose's point.

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All bank balance sheets are inherently runable, regardless of whether time deposits are involved. This most recent crisis had nothing to do with time deposits, and yet the potential to create a panic still exists. You don't resolve that by going to 100% reserves. IN a class at OCON 06 (dont'remember which) I remember the discussion coming up and the general though of the instructor is that you let banks decide. Some will got o 100% and some might not, but the idea that 100% suddenly provides intrinsic safety is a poor one.

One can and should make the case that the level of fractional reserves shouldn't be arbitrarily set by fiat, but that is certainly not the same thing as calling them immoral, per se.

How can a bank being able to beat any panic not be 100% safe for the depositors?

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Paul doesn't seem to understand this. btw I tried to listen to the vid, but the incredibly distracting effect of delivering a lecture while driving a car was more than I was willing to stomach. Yes, Paul, you can give a lecture while driving, spinning plates, and rubbing your stomach in a circle....

Why such a disrespectful attitude? And how do you judge his understanding on the subject when you are not willing to hear him out?

In fact he gave a good lecture where he made his argument clearly and rationally. I also had no problem hearing what he said, although it would of course have been better without the background noise. Now I do agree with the issue you have raised, and I think he made a mistake, but that does not justify your very disrespectful tone.

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Why such a disrespectful attitude? And how do you judge his understanding on the subject when you are not willing to hear him out?

Because the conclusion belies the misunderstanding. I've heard this argument, "the immorality of fractional reserve banking" dozens of times. It's like the one for God. Is there a reason I need to listen to it again? I find it rude when someone posts a link to quite a long video without the ability to even summarize his points in a quick summary, but then Paul doesn't actually discuss here much, he just does the occasional drive-by post.

How can a bank being able to beat any panic not be 100% safe for the depositors?

Other way around. Because if a bank goes to 100% reserves, that still doesn't guarantee it can beat any panic. A bank lends out money against all sorts of liabilities, and can experience a cash shortage based upon any one of its investments turning sour. Time deposits are only one form. If you extend this innane idea to the entire of a bank's financing, and thereby guarnatee it can survive a run, it can't actually BE a bank, i.e. it's not loaning money out to make more money.

It is the actuality of being a bank that creates the risk of inability to pay. It is part of being a bank. One can certainly debate if under a free market, there wouldn't be a market for this particular type of risk with some banks operating in sectors where they will actually and can afford to offer fractional reserve investing, and others choosing not to, but hte idea that the whole damn thing is immoral is incorrect.

Edited by KendallJ
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Because the conclusion belies the misunderstanding. I've heard this argument, "the immorality of fractional reserve banking" dozens of times. It's like the one for God. Is there a reason I need to listen to it again? I find it rude when someone posts a link to quite a long video without the ability to even summarize his points in a quick summary, but then Paul doesn't actually discuss here much, he just does the occasional drive-by post.

Ok, fair enough, you have heard the argument many times before and don't think Paul has anything new to offer. Only reason I can give you to wath the video is that he gives a well argued lecture that you may or may not enjoy. In the description to the video he has also stated what he is lecturing about, so you can judge for yourself if that is of any interest to you.

The only thing I find rude is your response to him. I think it's entierly unjustified. If you have a problem with him not giving a quick summary and not posting here often enough you should have said so instead.

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The only thing I find rude is your response to him. I think it's entierly unjustified. If you have a problem with him not giving a quick summary and not posting here often enough you should have said so instead.

I think that's a fair comment. Paul, if you check back, my apologies.

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Thanks for recognizing that, Kendall. :P

Np, I realize I ride the edge sometimes, but I can admit when I'm probably over. I think one of the strengths of the board is "self-moderation", i.e. when people will at least say "I think that was out of line." So thanks for that.

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Just FYI, I posted on this issue a while back: Fraud or Not?. Here's the post in its entirety, minus the final paragraph commenting on Reisman's rationalism:

From an Objectivist perspective, is there anything fraudulent about fractional reserve banking?

That question first occurred to me a few months ago, when I listened to Murray Rothbard's lecture "Banking and the Business Cycle" from the Mises Institute's generally uninformative Home Study Course in Austrian Economics. Rothbard insists that fractional reserve banking is fraudulent, but never adequately explains why.

Some searching online led me to this Objectivism Online thread on the topic. The arguments against fractional reserve banking seemed highly rationalistic to me, but I didn't know enough to draw any solid conclusions.

A bit later, I re-read Alan Greenspan's essay "Gold and Economic Freedom," including this passage in favor of fractional reserve banking:

A free banking system based on gold is able to extend credit and thus create bank notes (currency) and deposits, according to the productive requirements of the economy. Individual owners of gold are induced, by payments of interest, to deposit their gold in a bank (against which they can draw checks). But since it is rarely the case that all depositors want to withdraw all their gold at the same time, the banker need keep only a fraction of his total deposits in gold as reserves. This enables the banker to loan out more than the amount of his gold deposits (which means that he holds claims to gold rather than gold as security for his deposits). But the amount of loans he can afford to make is not arbitrary: he has to gauge it in relation to his reserves and to the status of his investments (Alan Greenspan, "Gold and Economic Freedom,"
The Objectivist
, July 1966, pg 109).

At this point, I'd say that I'm reasonably clear about the way in which fractional reserve banking works. Although I have some lingering worries (or perhaps just confusions) about the "money multiplier" created by the cycle of deposit-loan-deposit-loan (discussed by my friend Jimmy Wales here), I'm even far more clear about that than I was originally.

As for the proper legal status of fractional reserve banking, I cannot see any fraud in it, so long as all parties are adequately informed. If I know in advance that my bank might lend up to some fixed percentage of its total deposits rather than safeguarding them all for mass withdrawal at any moment, then how is that bank defrauding me -- or anyone else? After all, if the demand for past deposits exceeds the supply of reserves, then some procedure contracted by all in advance will have to be invoked. That might be painful, but it wouldn't be fraud.

Before I posted on this topic, I decided to read the section on fractional reserve banking in George Reisman's Capitalism. To my surprise, he's not just opposed to fractional reserve banking, but in favor of outlawing it as fraud. His critical philosophic argument comes in a section entitled "The Moral Virtue of the 100-Percent-Reserve Gold Standard":

What underlies the practical advantages of the 100 percent-reserve gold standard over any form of fractional-reserve system is its moral superiority. It operates consistently with the law of the excluded middle and does not attempt to cheat reality by getting away with a contradiction. It recognizes that lending money precludes retaining that money in one's possession, and that retaining money in one's possession precludes lending it. The 100-percent-reserve system follows the principle that either one lends money or one retains the money, but not both together, with one and the same sum money. In contrast, a fractional-reserve system applied to checking deposits or banknotes is a deliberate attempt to cheat reality. It is the attempt to have one's money and lend it too. It is a system fully as dishonest as all other recurring efforts that take place in one form or another in attempts "to have one's cake and eat it too."

Just as such attempts typically entail taking away someone else's cake, fractional-reserve banking applied to checking deposits or banknotes entails some parties gaining credit at the expense of other parties, and others unexpectedly being placed in need of credit. Again and again it results in financial contractions, depressions, and deflation, accompanied by widespread bank failures, which last represents the cheating coming home to roost. Again and again, individuals who believed they owned money, who would never have dreamed of lending out the money they needed to hold to make purchases and pay bills, and thus of lending, to the point of their own insolvency, wake up to learn that the checking deposits or banknotes they hold represent loans that have become uncollectable.

Imposition of the 100-percent-reserve principle in connection with checking deposits and banknotes is the imposition of financial honesty. It would require nothing more than that banks ask their customers whether in making a deposit or buying banknotes their intention was to lend money to the bank or to keep their money at the bank. In the first case, the bank's customers would receive a credit to a savings account or certificates of deposit, neither of which they could spend until such time as they withdrew the funds they had lent, which would entail equivalently reducing their savings account or redeeming their certificates of deposit. During the interval the bank, for its part, could lend the customers' money out, as it thought best. In the second case, the customers would receive either a credit to their checking account or banknotes, both of which they could spend as they wished. But so long as the customers held their funds in the form of checking accounts or banknotes, the bank could not lend or spend the proceeds its customers had entrusted to it. That money would be the customers' money, which they were not lending to the bank but merely keeping at the bank.

It follows from this discussion that it is mistaken to believe that the imposition by law of 100-percent-reserve banking in connection with checking deposits and banknotes would constitute government interference. It would constitute nothing more than the just exercise of the government's power to combat fraud--the fraud of having one's funds lent out despite the bank's deliberate creation of the impression that in making a checking deposit or purchasing banknotes one fully retained the possession of one's funds.

Shysterism in any form is always slippery. Thus if it occurs to anyone to argue that the banks' customers are not victims of fraud because they clearly know and understand that their funds are being lent out, then the answer is that in that case they would be parties to fraud. Their fraud would be the attempt to make payment to others not with money or reliable warehouse receipts for money, but with claims to debt. They would be engaged in the willful contradiction and deception of claiming to pay someone when in fact imposing on him the position of being a grantor of credit. (George Reisman,
Capitalism
, pg 957-8)

Woah, Nellie!

If a fractional reserve bank lends up to 90% of its total deposits in a laissez-faire capitalist system, its depositors are not dishonestly attempting to cheat reality by holding and lending their money. They are counting upon the quality of the loans of that particular bank, hopefully with good reason. They are also generally counting upon the fact that demand for deposits will be fairly evenly distributed over the large pool of depositors over time, just as Alan Greenspan noted. They are also aware that in times of crisis, their own deposits may not be available to them, hopefully temporarily but also possibly permanently. Where is the dishonesty or fraud in that kind of system? It's no more fraudulent than pooling risk with insurance.

The claim that payment to others in fractional reserve banknotes would be fraud is also unpersuasive. If Mary owes John $1000 for painting her house, John need not accept banknotes from Mary's fractional reserve bank if he regard those notes as insufficiently reliable. John could insist upon funds from a 100-percent-reserve bank -- or even gold. So how is John deceived and cheated if he accepts fractional reserve notes?

As far as I can see, the charge of dishonesty and fraud only makes sense if you assume that ordinary people are not competent to judge the quality of the financial institutions with which they deal. However, Objectivism certainly does not endorse any such forms of paternalism. Moreover, any legally competent person could understand that full-reserve notes (or in gold itself) would be less risky than fractional-reserve notes.

So while I'm no expert in economics, I cannot possibly regard Dr. Reisman's argument as a plausible justification for outlawing fractional reserve banking. On a philosophic level, the argument strikes me as highly rationalistic, in that its main line is basically a deduction from the idea that fractional reserve banking means depositing money in the bank to lend to others even while retaining the ability to withdraw it at any time. That does seem like a contradictory state of affairs -- if you drop the broader context of the activities of all the bank's other depositors.

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I for one cannot see how a bank can keep 100% reserves and lend out ANY money. 100% left on deposit means 0% to lend out since the gold cannot be in two places at the same time.

---------

A bank that has 100% reserves is actually a warehouse. Being unable to lend that money out and make interest, it would have to charge fees for storage. Now such a thing *could* be useful in a gold-based economy--a reliable, counterfeit resistant bearer receipt for (say) 100 grams of gold (slightly over three troy ounces) would be a heck of a lot more convenient in commerce than the 100 grams of gold (which would be quite a slug and ruin your pockets). Costs could be cut by the warehouse storing some fraction (like 90%) of the gold in a central facility.

Basically, when you deposit gold in a bank that is free to lend it out, it's really an investment, your "balance" is actually an IOU from the bank, just as a stock certificate is essentially an IOU from the company. If it's a checking account you are actually paying your checks in IOUs. Presumably, though, when you went to withdraw the IOUs (i.e., collect on the debt the bank owes you) from either a checking or savings account, the bank should hand you the gold, *rather than* a piece of paper. After all you are claiming your money.

I can imagine an institution offering both kinds of services at the same time--even making warehousing up to X grams of gold free for people with a minimum balance on the investment side of Y grams.

A place that offers both warehousing and investing *could* give you a piece of paper when you make a withdrawal--that withdrawal would in fact represent claiming your gold, and having the bank warehouse it for you, giving you your receipt.

In such a system, paper money would be one-for-one tied to gold somewhere, checking accounts (and checks) would in fact be bank IOU transfers--and this would make up most of the "money" out there and the result of the fractional reserve "creation of money out of thin air"

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A fractional reserve bank's fraction on loan should be a function of its deposits which are not presentable on demand. That would solve the panic problem. If one of the bank's loans defaults then only those customers who assumed the risk in exchange for interest would face the possibility of loss.

As far as the expansion of the money supply argument goes, there is no inflation as long as the value in goods and services created by the loans also expands.

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How can a bank being able to beat any panic not be 100% safe for the depositors?

Panic is irrational, beating it is often impossible, though with time it tends to dissipate.

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Libertarians have also discussed this topic ad nauseum. I don't endorse their general philosophy, but there was a recent post on the Volokh.com website that captures my own position pretty well. Here's the relevant excerpt (Block is the opponent of FRB):

...Block confuses property rights and contract rights. If I give the bank some cash and pay it to put this cash in a safety deposit box, then the bank can’t use that cash. It can’t lend it out to someone else; it can’t list it as an asset on its balance sheet; it can’t touch it without my permission. If the bank were to do so, then it would have engaged in theft, and the relevant employees would go to jail. Lawyers call this transaction a bailment.

But if I deposit some cash with the bank, I don’t retain my property interest. Instead, I’m making a loan to the bank and I obtain a contractual right to repayment on demand. If I demand my cash (plus interest, if any) and the bank fails to pay me, then I can sue it for breach of contract and demand expectation damages. If the bank were not a bank but just an ordinary borrower, and it was insolvent, then I have to race other creditors for its assets; otherwise, my contract right is converted into a claim in bankruptcy, and I have to share with other creditors. (Since it is a bank, I may well obtain full compensation from the government, but that is not relevant to the debate.)

If you asked the bank whether it might lend out your money, it would most certainly tell you that it would. So it is not lying to you, and there can’t be fraud. Nor is there any other contradiction, incompatibility, or problem with the arrangement. Depositors take a risk that the bank will breach the contract but anyone who enters a contract takes the same risk.

Block doesn’t seem to have any problem with contract rights per se, but he does have a problem with a person entering a contract that gives another person the right to demand assets that the first person might not have. But all contracts are like this. People enter contracts expecting that they will be able to transfer money, goods, or services when they are due, but everyone understands that intervening events might make the transfer impossible, impractical, or unwise. The other party obtains a right to obtain damages for breach of contract, but if every contract where the probability of nonperformance is greater than zero were considered fraudulent, we would have no economy.

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I have always recognized the general moral status of FRB. However, what is unclear to me is the issue of asymmetric information. In other words, the bank will always know more about itself than I can know about it. There are some clever accounting tricks to make it look like a certain amount of reserves are being held, when in fact they are not--I'm thinking of the so-called "Sweep accounts" in particular. Would the bank have to disclose to me when I open my account that they offer sweep accounts, and indeed that some customers have sweep accounts with them?

Maybe this isn't an issue.

Edited by adrock3215
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