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Fractional Reserve Banking versus Ayn Rand's Ethics

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Paul McKeever

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One thing that is confusing me here is that the different banks under the gold standard before central banking came to America printed their own separate currency for their own bank. And so in creating credit (which potentially could and would be the banks paper money correct?) if it causes inflation, doesn't it only apply to the banks own currency? Or is purchasing power universal where all banks are effected by all the others? I'm muddled on this point.

It would only devalue the currency of the issuing bank.

Each bank currency would be exchangable for every other bank currency in a currency exchange market (we have this today, it's called the foreign exchange market, where I can take my dollars and buy euros, or my yen and buy reais). In so much as market participants view the currency of a particular bank as being secure, then that banknote will trade at a premium to other, less reputable, banknotes on the market. If, in general, all bank practices are shady and suspect, then market participants would choose to hold gold, and so the currency exchange market would diminish and the medium of exchange would be gold. This is unlikely, because in a free market, if all banks were shady, there would be a startup opportunity for a more trustworthy bank. Personally, I think practices would differ across banks, which means that reserve ratios, banknotes, denominations, etc, would all vary depending on the issuing bank.

What I'm against is the idea that, say, someone brings in 100 ounces of gold and the bank issues notes for more than 100 ounces of gold (whatever denomination), because that would be fraud.

That's fine. But what you are, in effect, saying, is that you think FRB is morally wrong because it is fraud, and that it should not be permitted in a free society. I happen to disagree with you, because I think that an individual and a bank can draw a contractual agreement stipulating the terms of the deposit, including the amount of reserves that a bank holds in the vault.

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There is no difference in principle between loaning out more money than it has in reserve or loaning out less money than it has in reserve.

In that case, I'd love to loan $100,000,000 that I don't have at 1% a year. See the problem?

So, I guess it comes down to what is fractional reserve banking? Is it managing loans and debts in such a way (dynamically) so that one can loan out more than one has control of? I don't see how. And if more gold bank notes are printed than what covers the gold, then that is fraud.

It is having more outstanding on-demand claims to money (gold) than you have money (gold). You clearly understand the concepts (if not all the lingo) and are against it.

The main issue Paul talks about isn't fraud, which is mostly being discussed in this topic. In fact he dismisses the idea of fraud quickly in that link.

He dismisses the wrong problem.

Fractional reserve banking is not (necessarily) fraud against the depositor. Simply informing him of the conditions of his deposit eliminates this concern (i.e. the depositor agrees to the specified conditions). It is also not fraud because it devaluates outstanding money claims (though it does). Again, if this was informed to the depositor it cannot be considered fraud against him.

FRB is, necessarily, fraud against everyone else.

Paper money is, supposedly, a property title to the actual money (gold). Under 100% reserve banking this is always true - while individual ounces of gold are fungible (i.e. one ounce is as good as another, you cannot ask to have one specific ounce of gold, just one ounce of gold of a certain fineness) in 100% reserve each fraction of an ounce is owned by exactly one person at any given time. Whether this ownership is documented by posession of a paper note or by a balance on a checking account does not matter. Future claims also do not matter: if I owe the bank 10 oz payable tomorrow, they cannot lend that much out today.

FRB breaks the property title characteristic of paper money. Even when the depositor is made 100% aware of the practice, each note is no longer property title to a specific amount of gold. Rather, it becomes a contractual claim to that amount of gold limited by the conditions of the contract (i.e. "I will pay you face value on demand but I don't really own enough currency to pay everyone so beware"). While this is not fraud against the depositor (if forewarned) it is fraud against everyone else - if this paper money is passed off as money.

True, this other fraud could also be mitigated in the same way - by printing "50% RESERVE MINIMUM" (or any %) and NOT A PROPERTY TITLE on the note itself, for instance. The thing is, a completely honest FRB scheme such as this one is also completely untennable. The moment the 50% bank note hits the market, marked as such, it ceases to be fungible. It is ostensibly not gold. While people might comfortably use these notes for pocket money, the dis-incentive for holding significant amounts of ones wealth in fractional notes would be considerable.

What this would mean, in a free market, is that people receiving large payments in "fractionals" would immediately head to the bank, claim the money and deposit it in a 100% reserve bank. Same amount of gold, no risk. This would push reserves upward, since low fraction notes (or accounts) would not remain outstanding for long.

It would also mean that fractional money would trade at a deficit against real money - and this is a strong dis-incentive for depositing in fractional accounts, since you put in 1 oz and get a 1 oz note (or balance) that is worth 0.97 oz (or whatever) on the market. This would also push reserves up.

Thus under an "honest" FRB system the margin for reducing the reserve would be under constant pressure, which in turn would mean the additional profits from the practice would be small, which in turn would mean the yields on fractional deposits would be low. I find it very unlikely that it would be worth the trouble.

Profiting significantly from FRB depends on defrauding the market at large - by pretending that a 1 oz note actually represents 1 oz of gold when it does not. Strip away the fungibility and there is no fraud, true, but the moment everyone knows that "Bank X" notes are not titles to money but contractual constructions that may or may not be backed by money, FRB falls apart. People are not stupid.

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While this is not fraud against the depositor (if forewarned) it is fraud against everyone else - if this paper money is passed off as money.

You and I are in substantial agreement on just about everything, but I disagree that there is any fraud going on. The bank is not passing a banknote off as money, it is passing it off as a claim to money. Gold is money, not banknotes. Banknotes are a stand-in for money--i.e. gold--to allow exchange transactions to take place conveniently. There is no fraud involved here. The bank is not making a claim that the banknote is money as such; it is making the claim that the banknote is exchangable into money upon redemption, while acknowledging a default risk.

It's the same concept as a bond. The borrower always has the possibility of defaulting to the lender, but bonds can be traded around and act as a stand-in for actual money. Under your view, you would have to also claim that a bond is fraudulent. I think that we need to start viewing banknotes as bonds, because that's really what they are. A deposit in a financial institution is a loan to the financial institution. As is typical, all loans are subject to default risk. There is nothing fraudulent about this.

My thought is that, in a free market, there would be banknote insurers, in the exact manner as exists today bond insurers. Higher up, there would be reinsurance companies that act as insurers to insurance companies (we have these today to cover all types of insurers).

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Let me run another analogy on you here, because I still think we are talking past one another. Basically, I consider a bank handing out demand claims to gold that they do not have or cannot get is fraud. But maybe the "can get" is the crux here. And maybe one reason all these banks these days are having problems in the financial crises is because they were making transactions based upon money they can get (by inter-bank loaning at low rates), but the whole thing falls apart if they cannot get it and the on demand comes true with withdrawals.

Here's the analogy: I work in a custom picture framing gallery. A customer comes in and pays, say, $150 to get something framed. I take his money and give him a receipt. That receipt is a claim on future production, the completed frame job. So, in a sense, he has paid for something that does not yet exist. We have to make it for him. But, if I took his money and gave him nothing in return, and kept his money, then that would be fraud.

So, yes, it is possible that a bank could loan out gold notes as claims to gold that it would get some time in the future, once it has earned them. And that would not be fraud, so long as the bank is profitable enough in receiving gold to cover the on demand customers who come in today and want their gold. I think it is a risky thing to do, however, because one cannot predict future earnings exactly. One can say based on the past we expect to bring in, say, 300 ounces of gold per day, and therefore they can loan out up to 300 1 ounce gold notes every day. But if they cannot deliver on the on demand for gold, they are in trouble, because they didn't keep enough gold on hand to satisfy the demand for gold. And I disagree that if I make a deposit in the bank, say my checking account, and they cannot cover that, then it is not fraud on their part. You are saying it is not fraud because I agreed to the terms that it may not be available at a moment's notice when they receive a check that I have written to someone. Basically, I am paying them to be able to pay out my checks on demand (provided my account is not overdrawn).

I mean, if you don't agree with that, then I would say the same thing as a previous poster, I'll print you out a note saying $100,000 claimed to the holder and charge you 10% interest for doing something with that note, but you have to pay me in gold. The problem is that I don't have $100,000 to give the the holder of that note, and therefore it would be fraud for me to try to pass it off as money or as a claim to money. So, insofar as banks do this and if this is fractional reserve banking, then it is fraudulent. If they are doing something like what we do in picture framing and it is a claim on future money, then OK, that can be worked out.

I'm just confused on what fractional reserve banking means. If it means handing out on demand notes for money that does not exist and will not exist, then it is fraud. But at no time can they just print out gold notes like candy without taking the responsibility to insure that they can get enough gold to cover those notes, and relying on other banks to back you up if you hand out too many gold notes is rather foolish, as we can see what happens when those gears no longer turn -- banks collapse overnight like dominoes.

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As to the legality, I completely concur with Hunterrose and Kendall - banks should be allowed to offer fractional accounts, and customers who take them do so on their own heads. As I have argued before, and as Paul himself notes early on in his video, in the past much of it (but not all) was definitely fraud and theft that should have been nipped in the bud by the government of the day, but today everyone knows more or less what the situation is. From the perspective of trading practice, fractional banking is no more automatically immoral than short-selling, as both are the issuing for value of a claim for what you do not own.

That being said, fractional reserve banking is totally without merit. The extra nominal lending does not lead to lasting additions to total real capital because it does not alter the actual fundamentals that determine that total. The only result (at best) is a privately-caused inflation that increases the mere nominal value of that total capital, and increases the total risk in the economy using that money supply. That being the case, there are no sound principles by which a bank can determine an appropriate reserve fraction because there is no appropriate fraction other than 100%.

And of the inflation element? Yes, it lowers the purchasing power of a unit of money, and yes it even lowers the purchasing power of gold itself (sorry Adrock), but again that is not automatically grounds for reaching for your protest signs and bullhorns (or video cameras). It is the result of private action of private individuals, not engaging in any fraud. Not even a third party is defrauded as Paul argues, the a reason similar to how shareholders are not defrauded by naked short-sellers: you own objects or claims thereto, but you do not own the market value of those objects or claims thereto, and are not the victim of robbery merely because that market value is decreased. The resulting decrease in the purchasing power of the money supply is no more immoral in that context as the same happening as a result of a rich gold-find coming on stream (or as in Paul's example of tobacco, a bumper crop being harvested). Given that fractional banking is without merit, the smart thing to do is simply either to demand payment in specie or to slap discounts on the tokens issued by banks that indulge in it, just as was done in times past. Beyond that, fluctuations in the purchasing power of the currency are to be just lived with and dealt with in whatever way people judge appropriate (eg derivatives to transfer risk).

So, leaving aside the issue of government involvement, fractional reserve banking isn't immoral in the sense that it is some heinous fraud, not immoral in the way that is grounds for getting all riled up and itching to storm the citadels of high finance to chase out mighty evildoers - but it is immoral in the more humdrum manner of being impractical because it is irrational and doesn't contribute to the production of value. Without government its presence would be minimal even without recognition of its complete lack of merit, and in that light the immorality of it is not a case of embezzlement of billions through skim scams and more along the lines of a case of a mostly-harmless loser with a gambling problem and who most people eventually learn to avoid. Take away the government involvement in finance and the immorality concerned thereafter is for customers to deal with on their own according to their own judgement. It is no more to be outlawed than slot machines are.

JJM

Edited by John McVey
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I'm just confused on what fractional reserve banking means.

Fractional Reserve Banking is having less reserves of specie on hand to settle all claims thereto if they were to be presented all at once. It does not mean that a bank has insufficient assets, only that its other assets aren't money. If there were to be an orderly shut-up of the bank those other assets could be sold for specie and then the claims settled in full. Were this done equally orderly across the whole economy, including where all prices are free to change according to market forces, even the entire fractional system could 100% settle its demand-deposit debts. The problem arises when the shut-ups aren't orderly and banks are forced to offload their assets at fire-sale prices, resulting in the inability to satisfy depositor demands through insufficient funds.

If it means handing out on demand notes for money that does not exist and will not exist, then it is fraud.

No it isn't, no more than a farmer selling rights to a crop he does not have now but will have in the future is fraud. And, by the way, those rights - called futures - are also liquid and regularly traded on financial markets. There's no fraud involved in those markets any more than there is fraud in the juggling act of fractional banks trading with each other and covering each other's minor shortfalls through clearinghouses etc.

But at no time can they just print out gold notes like candy without taking the responsibility to insure that they can get enough gold to cover those notes, and relying on other banks to back you up if you hand out too many gold notes is rather foolish, as we can see what happens when those gears no longer turn -- banks collapse overnight like dominoes.

Indeed, which is why you should be sure of the soundness of the practices of a bank you're considering having accounts with. As it happens, that includes eschewing fractional banking completely, but as I've noted elsewhere the reason for that action is not the erroneous claim of fraud.

JJM

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Here's the analogy: I work in a custom picture framing gallery. A customer comes in and pays, say, $150 to get something framed. I take his money and give him a receipt. That receipt is a claim on future production, the completed frame job. So, in a sense, he has paid for something that does not yet exist. We have to make it for him. But, if I took his money and gave him nothing in return, and kept his money, then that would be fraud.

What is missing in this scenario is any place for the concept of collateral. Banks have collateral in exchange for their loans. IF the collateral is priced correctly, then the bank can always assure that it controls assets greater than or equal to the value of all of its issued notes, at whatever fraction it may be operating.

The hazard of FRB is the monetizing of assets that are not actually gold, because the value of assets changes over time while the mass and density of a specified quantity of gold does not.

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And of the inflation element? Yes, it lowers the purchasing power of a unit of money, and yes it even lowers the purchasing power of gold itself

As usual we are in agreement, but I don't understand the mechanism by which this would occur...Why would the purchasing power of gold itself necessarily fall? So, given what you said: if Bank A takes in deposits and prints more notes than it can back with gold under the guise of FRB, then gold itself will lose purchasing power? Since the supply of gold has not changed, I don't see how this is the case, unless you're referencing the velocity of money, or something else. Other than that I don't see it, given the traditional MV=PY equation.

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As usual we are in agreement, but I don't understand the mechanism by which this would occur...Why would the purchasing power of gold itself necessarily fall?

Obviously, if the gold notes are being used as the medium of exchange, and all of the gold notes cannot be covered by gold exchanges, then the real value of those notes will fall. That is, if one wants to receive gold notes for money, and one knows that a certain percentage of those notes cannot be redeemed for gold, then one will ask for more gold notes during the purchase -- i.e. generally higher prices will be demanded for goods and services.

The lowering of the value of the gold itself may come in when people are uncertain about the value of the gold due to the uncertainty about the value of the notes (in terms of how much gold one can actually get for them). In general, I would say uncertainty in the money supply (notes or gold) would lead to higher prices in either the gold notes or even in gold. That is, the uncertainty in what gold or notes can buy one, would lead to everyone wanting more gold or notes for goods and services. So, it is not that the supply of gold would increase (everything else being equal), but people would demand more of it -- i.e. prices would go up to reflect the uncertainty.

Replying to an earlier comment, yes, I realize banks have collateral for their loans, but I would think the bank could not claim that collateral unless the borrower defaulted on paying his loan. I just bought a car on credit, and I don't think the bank could reposes may car in order to cover their short-fallings if they cannot come up with cash to cover their transactions. I don't think they can do that, but even if they could, it would be foolish to act on it because I am paying for my car. If they repossessed it and had a fire sale then they wouldn't get that much cash for it to cover themselves. So, collateral is good to have when loaning money out, but, depending on the terms, that collateral is not something the bank owns unless the borrower defaults. So, I don't think a bank can use collateral as an asset; at least not to cover short-fallings due to, say, bad management.

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FRB banking entails taking a deposit for 100 ounces of gold and printing 100+X notes.

No, that's fractional gold reserve.

You have to break apart the two concepts of fractional gold reserve and fractional reserve banking.

In fractional gold reserve, you print more currency than is backed by deposited gold, so the actual amount of currency (notes) is greater than the gold in the bank's reserve.

100% gold reserve and fiat currency are the two ends of the gold reserve spectrum; they set the amount of currency that can be printed based on a gold reserve, but they have nothing to do with FRB.

FRB increases the non-currency portion of the money supply (M1) by increasing bank deposits beyond what is backable by currency (not by gold backing that currency). They do that by accepting things other than gold as backing for the currency, like real estate, cars, etc. There is nothing wrong with doing this, it doesn't decrease the gold-value of dollars, because the values of the other backers are estimated in terms of gold-backed dollars, but it might arguably decrease the value of gold, because it reduces its importance as a backer of money. By having gold act as the basis of currency, but not the primary backer of money (two different things), FRB allows gold to be used efficiently for its alternative uses, such as jewelry, dentistry, electronics, etc.

The bias towards gold as a backer of currency is arbitrary, given other available backers have objective market value. This should not be confused with the bias towards gold as currency, which it is eminently suitable for, given its characteristics (divisible, durable, valued, etc.) But once you get away from gold as currency, and make it simply a backer of currency (or abandon gold completely), you abandon the relevance of divisibility, and physical durability of dollar backing assets. The acceptance of, say, tulip bulbs as backers of loans, and thus of money, can lead to dangerous bubbles and the subsequent devaluation of M1 below the gold-measured value of the backing commodities. That is why the method and strictness of evaluating loan collateral is the key to whether FRB is sound/moral or not.

(edit:typo)

Edited by agrippa1
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That being said, fractional reserve banking is totally without merit. The extra nominal lending does not lead to lasting additions to total real capital because it does not alter the actual fundamentals that determine that total.

I disagree with this. Loans are a way for an individual to create capital using the future value of that capital. For instance, a man who borrows $1M to build a house, uses that money to hire labor to build the house. When he is finished he has a new piece of capital, a completed house that adds $1M or more to the total capital in existence. Over the course of the next thirty years, he increases his productive output beyond his consumption by an amount equal to the total payments of his loan, increasing, by definition, the total amount of wealth/capital in existence.

For another instance, when a man has a sound idea for a new business, he borrows against the value of that idea (and whatever physical collateral he has) and builds a company which increases the productivity of workers, increases the buying power of customers, and increases the processing of raw and recycled materials to increase the total value of capital in existence.

If, in either of these cases loans were not available, the house or the company would not have been built.

Loans are roughly the equivalent of taking a portion of harvest to put against seed for the next harvest. This is your example of a farmer selling future crops, except the farmer uses some of the proceeds of that sale to buy seed, fertilizer and equipment, to bring about the existence of that future crop.

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Replying to an earlier comment, yes, I realize banks have collateral for their loans, but I would think the bank could not claim that collateral unless the borrower defaulted on paying his loan. I just bought a car on credit, and I don't think the bank could reposes may car in order to cover their short-fallings if they cannot come up with cash to cover their transactions. I don't think they can do that, but even if they could, it would be foolish to act on it because I am paying for my car. If they repossessed it and had a fire sale then they wouldn't get that much cash for it to cover themselves. So, collateral is good to have when loaning money out, but, depending on the terms, that collateral is not something the bank owns unless the borrower defaults. So, I don't think a bank can use collateral as an asset; at least not to cover short-fallings due to, say, bad management.

The bank has a lien on your car until you complete the last payment, so they do effectively own it. If the banks needs to convert this asset to cash, they can sell the loan and the lien to another bank. They do not have to repossess your car to sell it.

Reselling mortgage loans and liens on over-valued property is precisely the root cause of the current credit bubble.

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Why would the purchasing power of gold itself necessarily fall?

Because even taking into consideration the discount placed on fractional notes the total money supply has been increased. This then lowers the value of an individual unit of that money supply independently of how a particular unit may be constituted. The issuance of redeemable notes thus dilutes the purchasing power of gold because they are a substitute for gold. This effect would only not occur if the discount on the notes was so great that the total trading value of the money supply was not increased. That result that is of course possible through the market value of a note being set to match the reserve ratio of the issuer (eg a 90% reserve note will trade at 90% of its face value), but that wont occur for so long as at least some people still think there is some merit in the practice and don't demand a discount of sufficient magnitude to cause that.

Since the supply of gold has not changed, I don't see how this is the case, unless you're referencing the velocity of money, or something else. Other than that I don't see it, given the traditional MV=PY equation.

V and Y need not change. It's just a matter of recognising that there are other media of exchange being used besides specie and 100% reserve. If we say M = G + F, where G is gold (including the portion of fractional tokens that are backed by actual gold) and F is the unbacked portion of fractional tokens' face value, an increase in M because of an increase in F will still act to raise P even if G is constant. Since G and F are interchangeable in the market place the ratio of G/P falls and so the extra F thus devalues G. It's the same effect were another form of specie to grow popular alongside gold, say silver for small change.

JJM

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I disagree with this. Loans are a way for an individual to create capital using the future value of that capital. ... If, in either of these cases loans were not available, the house or the company would not have been built.

I've argued this point elsewhere extensively. The problem with that argument is that it commits the fallacy that Bastiat identified in his argument on the seen versus the unseen. What is seen is the particular investments made with the new unbacked money supply - and what is not seen is the crowding out of other investments elsewhere (actually a slightly greater amount's worth, too, resulting in a small net negative).

The root of what determines the amount of real capital in existence is people's relative preferences to consume now versus later, which becomes manifested in the financial markets as the natural rates of interest and profit demanded by potential investors for the various associated risk levels. Issuing loans based on fractional reserves does not alter those preferences. It acts to lower the rate of interest on loan assets temporarily, pushing it below what the market demands for that risk level, thereby encouraging people to pull some of their investments out or merely to amend downwards plans to invest in the future, which in turn acts to pull interest rates back up again until the aggregate result is little different from what would exist had no fractional issuance been made (actually, slightly worse off, growing more so to the extent of new risk generated). The only thing that results is a shift in the composition of real assets and who owns them.

This is your example of a farmer selling future crops, except the farmer uses some of the proceeds of that sale to buy seed, fertilizer and equipment, to bring about the existence of that future crop.

Not quite. The reference to futures was simply to put to bed the notion that selling what one does not own is fraud. The trade in futures is not an example of fractional banking if the purchaser is forwarding money (ie making a loan plus purchasing risk from the farmer) that either is or is 100% backed by specie.

JJM

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Because even taking into consideration the discount placed on fractional notes the total money supply has been increased. ....V and Y need not change. It's just a matter of recognising that there are other media of exchange being used besides specie and 100% reserve. If we say M = G + F, where G is gold (including the portion of fractional tokens that are backed by actual gold) and F is the unbacked portion of fractional tokens' face value,

The M in that equation represents the monetary base, not a monetary aggregate figure. The monetary base of a free economy is M=G+R, where G is gold in circulation and R is reserves held in bank vaults (you could make room for silver or other commodities as well, but for simplicity sake I am just assuming Gold to illustrate). If we go to the equivalent of M3, we would include money market funds in our "money supply" as well. Either way, there is no real reason to include 'banknotes in circulation' as part of the monetary base of a free market economy, any more than there is a reason to include 'all commercial paper in circulation' as part of its monetary base.

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The M in that equation represents the monetary base, not a monetary aggregate figure. The monetary base of a free economy is M=G+R, where G is gold in circulation and R is reserves held in bank vaults (you could make room for silver or other commodities as well, but for simplicity sake I am just assuming Gold to illustrate).

Again, I think we are talking past one another. Even if gold is being used to back the gold notes, since the gold notes are actually what is in circulation and being used as medium of exchange, then effectively the gold notes are the money. That's why printing up more gold notes than there is gold is inflationary, because it is increasing the supply of money (or what is being used as money). So, one cannot say that since the quantity of gold does not increase that therefore the quantity of money does not increase. If more gold notes are printed without being able to be backed directly by gold (because the quantity of gold is static, but the notes are increasing), then the money supply is increasing.

And I still maintain that printing more gold notes than there is gold is the equivalent of writing a check for more than is in one's account, which is fraud.

While it is true that commodities other than gold can be used to back bank notes, this doesn't change anything. If one throws in, say, oil reserves or real estate to back bank notes, then the same principle applies. If the notes increase to more than the total amount of whatever commodity or commodities is being used to back the notes, it is fraud because effectively the bank is claiming it has more backing up its notes than it actually has to back up its notes. Again, this is like writing a bad check. Of course, if one can turn around and put more money into one's account before the check clears, then it is not fraud, and in fractional reserve banking, they seem to be doing that. They are temporarily borrowing money to cover themselves, just as you could get a cash advance on a credit card to cover a check you write. But you can't keep doing this, for obvious reasons. Somewhere along the lines it has to all balance out, and if the banks are effectively borrowing to cover themselves due to the fractional reserves, then eventually it will catch up with them, just as it has in the current financial crises.

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The M in that equation represents the monetary base, not a monetary aggregate figure. The monetary base of a free economy is M=G+R, where G is gold in circulation and R is reserves held in bank vaults (you could make room for silver or other commodities as well, but for simplicity sake I am just assuming Gold to illustrate).

To begin with, what I said stands. The extra fractional notes increases the aggregate money supply, and as it is the exchange of that which determines prices (along with velocity) those notes will reduce all prices unless their face value is sufficiently discounted.

On a technical note, I have always understood M to be the aggregate of that which is used as ready money as a common medium of exchange. I concur with a quote on the matter by William Boyd in a letter he wrote to William Pitt the Younger, which quote is regularly provided by local Austrian Gerard Jackson:

By the words ‘Means of Circulation, ‘Circulating Medium’, and ‘Currency’, which are used almost as synonymous terms in this letter, I understand always ready money, whether consisting of Bank Notes or specie, in contradistinction to Bills of Exhange, Navy Bills, Exchequer Bills, or any other negotiable paper, which form no part of the circulating medium, as I have always understood that term. The latter is the Circulator; the former are merely objects of circulation.

Notice that this definition includes a reference to your (correct) statement that commercial paper is not part of the money supply, but that all notes are. In a modern context, this would be expanded to include cheque accounts (which are a variant on notes) and demand-deposits from which direct debits can be made (effectively electronic notes). All of those together are used as ready money, circulating as media of exchange, and whose separate vicissisudes affect the prices of what they may pay for and consequently altering the value of the different components of the total available media of exchange.

JJM

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To begin with, what I said stands. The extra fractional notes increases the aggregate money supply, and as it is the exchange of that which determines prices (along with velocity) those notes will reduce all prices unless their face value is sufficiently discounted.

I think that, in order to not talk past each other, as Thomas is saying, we should straighten out our definitions. Here are the definitions I am using. I start first with the definitions used today, under the current fiat system.

M0: Physical currency in circulation + physical currency held in reserve accounts at the Fed.

M1: M0 + demand deposits (i.e. checking account deposits).

M2: M1 + time deposits, savings deposits, and non-institutional money-market funds.

M3: M2 + large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets.

So, in a free society, where currency is not issued by fiat, but rather by private bank:

M0 (monetary base): Actual Gold in circulation + actual gold reserve held in bank vaults

M1: M0 + banknotes + demand deposits (checking accounts)

M2: M1 + small denomination time deposits + savings deposits + non-institutional money market funds

M3: M2 + large denomination time deposits + institutional money market funds + repo agreements

Are these the same as you would hold?

Edited by adrock3215
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I think that, in order to not talk past each other, as Thomas is saying, we should straighten out our definitions...

So, in a free society, where currency is not issued by fiat, but rather by private bank:

M0 (monetary base): Actual Gold in circulation + actual gold reserve held in bank vaults

M1: M0 + banknotes + demand deposits (checking accounts)

M2: M1 + small denomination time deposits + savings deposits + non-institutional money market funds

M3: M2 + large denomination time deposits + institutional money market funds + repo agreements

Are these the same as you would hold?

Everything else being equal (not increasing or decreasing) then your definition of M1 is crucial to the discussion of fractional reserve banking as you have been defining it. Clearly M1 increases if the banks issue more bank notes than is covered by their gold reserves, and I call that inflationary (an increase in the money supply). The earlier formula you stated about velocity and price is misleading in the sense that inflation may not always show up as a general increase in prices, because in a free society, means of production and competition are constantly working to decrease prices, so a general increase in M1 may not show up as an increase in prices. But there is an increase in the money supply (M1) and some of that is not actually backed by gold or other commodities. Basically, it is more notes chasing goods and services, which, everything else being equal, will tend to drive up prices, though this may not show up as an actual increase in prices due to production.

In other words, the modern "basket of goods" the Fed uses to determine the rate of inflation is misleading as to the real rate of inflation. For example, the price of computers (in terms of what they can do) is continuously coming down in price (due to little regulations on computers), which can offset things like automobiles which are continuously going up in price (due to regulations). And in modern times, M1 has clearly increased over time, roughly ten times as many Federal Reserve notes in circulation when compared to the 70's, which is one reason gold is roughly ten times the cost that it was in the 70's (when we were on somewhat of a gold standard).

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I've argued this point elsewhere extensively. The problem with that argument is that it commits the fallacy that Bastiat identified in his argument on the seen versus the unseen. What is seen is the particular investments made with the new unbacked money supply - and what is not seen is the crowding out of other investments elsewhere (actually a slightly greater amount's worth, too, resulting in a small net negative).

I fail to see how the broken window fallacy applies to the creation of new capital, vice the replacement of destroyed capital addressed in Bastiat's fallacy.

I also fail to see how the money supply can be said to be unbacked, given that the bank owns collateral greater in value than the money lent.

Finally, I fail to see how the pooling of small savings accounts, any one of which is not great enough to be useful for significant investment, can be seen to be diverting that money from "other investments." Truth is, if I have $100, trying to invest it into a new business or someone's house would require a great deal of bookkeeping, which would have to be subtracted from the interest I might gain from that investment. The cost of that bookkeeping will have the marginal effect of decreasing total investment.

The bank provides a service of pooling my money with other small depositors, so they can aggregate the savings and invest them in multiple loans. This has three benefits: First, it keeps me from having to pay bookkeeping expenses for each of the loans in which I might invest. This is a cost savings to me and results in higher return on my investment. Second, it allows me to spread my investment over a large number of loans, thereby reducing the risk of any one loan failing, which effectively increases my return, due to my bias against downside risk. Third, it allows me to spread the risk of near term emergencies, and thus the need for access to ready cash, across all borrowers, so that the amount of cash required is equal to the average amount of cash needed times the probability of needing that cash (if I was on my own, I'd need to have that amount of cash available all the time).

(edit on previous post, I was using M1 erroneously, I should have said M2)

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Are these the same as you would hold?

M0 = Specie in circulation, but excluding specie held in reserve for notes or deposits. The reason for the exclusion is that specie held in reserve is withdrawn from circulation, physically kept inactive in vaults, until redemption of notes or deposits, because those notes and cheques are being circulated in their stead (which is the point of having them).

M1 would be as you state. The bank notes and demand deposits would be the entire amounts outstanding, not just that portion which has an associated reserve.

After that I am not fussed about the higher M's, a position in which I'm not alone. The higher the M number the more frequently the instruments being referred to would drop in and out of use as media of exchange, making it pointless to try to be accurate in measuring their quantity to determine the money supply. For instance, a customer may choose to hold a bill of exchange to maturity as a low-risk-low-return investment or negotiate it away to pay for something. Similarly, if that customer moves from region A to region B, the residents of B may not be in the habit of accepting bills directly as means of payment, necessitating the customer to liquidate it for cash instead. Thus whether the intruments in higher M's constitute media of exchange depends on the intentions of customers and others who might or might not accept them as a means of payment.

I take M1 as the main figure of interest because its components are always media of exchange. They are what constitute ready money, always available to be spent and accepted because it can be taken for granted that others will act similarly. Additionally, the more sophisticated a financial system and its customers become, the more sense it would make to include savings deposits in M1 rather than M2 because of the increasing acceptance of paperless direct-debit transactions and the eventual disappearance of savings accounts not having any of the various forms of that facilty.

JJM

Update:

Alternatively, M0 can be all specie whether in circulation or in reserve, while M1 is M0 plus the portion of notes and demand deposits that isn't backed by specie held in reserve. In this scheme M1 comes to the same number as the above scheme anyway.

Edited by John McVey
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I fail to see how the broken window fallacy applies to the creation of new capital, vice the replacement of destroyed capital addressed in Bastiat's fallacy.

Ah, I apologise, I'm muddled in whose idea I meant. If not Bastiat, then I think it was Hazlitt. Whoever it was, it was reference to the fact that that it is the task of the real economist to look past the immediately obvious effects of some action and into what also happens elsewhere as another consequence, which the non-economist frequently fails to identify.

I also fail to see how the money supply can be said to be unbacked, given that the bank owns collateral greater in value than the money lent.

Actually, I repudiated the idea of the money being totally unbacked in a response I made to Tom yesterday. I explained that all fractional money could be completely settled in specie by selling the assets prior purchased with that fractional money, if the process were orderly. The problem isn't fractional money allegedly being "unbacked" but a mismatch between the repayment-requirements profiles of the bank's assets portfolio on the one hand and the liabilities and equities portfolios on the other.

Finally, I fail to see how the pooling of small savings accounts, any one of which is not great enough to be useful for significant investment, can be seen to be diverting that money from "other investments."

It isn't the pooling function of retail banking I was referring to, it was the creation of new money to purchase investments with in the face of a lack of change in the fundamentals that determine the total capital in the economy (primarily time-preference). I explained what I meant in the other thread - not too well, I admit, but all the information you need is there. In those circumstances the new investments in one area as made possible by the new money lead to other investments elsewhere being cancelled because the total market for investments in real terms hasn't changed.

You're also conflating the issue of fractional banking in particular with the general practice of banking. Every one of the services of retail banking you describe can take place perfectly efficiently without any recourse to fractional banking. I even once looked up the actual statistics for the Australian financial system when I was doing a series of posts to HBL and I noted that even today the supply of loanable funds from non-fractional sources outweighed fractional sources - all sourced from retail-level investors like you and I - by about seven to one.

JJM

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M0 = Specie in circulation, but excluding specie held in reserve for notes or deposits. The reason for the exclusion is that specie held in reserve is withdrawn from circulation, physically kept inactive in vaults, until redemption of notes or deposits, because those notes and cheques are being circulated in their stead (which is the point of having them).

M1 would be as you state. The bank notes and demand deposits would be the entire amounts outstanding, not just that portion which has an associated reserve.

.....

Update:

Alternatively, M0 can be all specie whether in circulation or in reserve, while M1 is M0 plus the portion of notes and demand deposits that isn't backed by specie held in reserve. In this scheme M1 comes to the same number as the above scheme anyway.

I think I agree with this better. The money being counted has to be that which is generally accepted as a means of exchange and actually be in circulation. Otherwise, if someone had a large cache of gold and never used it for anything (or say a newly discovered gold mine that has not been worked), then this would have to be counted as money, even though it wasn't being used as such. For example, burying your hundred thousand dollar in your back yard and never digging it up to use it makes it not countable as money -- at least not until it is dug up and put back in circulation.

I do have a question, however, are credit cards countable as money, since they are being used more and more as a means of exchange? I would say probably not, since the credit card represents actual money being transferred from the card holder to the merchant. Basically, credit cards and debit cards are just an easier way of facilitating exchange, but doesn't add more money in circulation. They might, and I stress might, lead to more demand for goods and services, since those goods and services can be paid for with a credit card instead of the customer having to wait until he had enough savings. Still, the credit card is back by real currency. Some of the government issued debit cards are effectively an increase in M1, since they have numbers electronically printed on them, which would be like printing more M1 notes not backed by any commodity. So, I'm not sure I would leave them out of the M1 figure. Though, I guess someone has to get real money notes somewhere along the line, so maybe it all reverts back to notes in circulation. Or would you handle such things as credit cards and debit cards under M1 as demand deposits -- i.e. similar to checks?

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Alternatively, M0 can be all specie whether in circulation or in reserve, while M1 is M0 plus the portion of notes and demand deposits that isn't backed by specie held in reserve. In this scheme M1 comes to the same number as the above scheme anyway.

Ok, given that...your claim was that a bank printing more banknotes than gold reserves causes gold to lose purchasing power. What I said was that this position is entirely unjustifiable, that only banknotes would lose purchasing power, not gold itself. That's why we began to define money, because people were muddying the distinction between money and substitutes for money.

There is no reason to include banknotes in the supply of money, but not include mortgage notes, auto notes, Treasury notes, or corporate notes. We have to get away from seeing notes as money, which isn't easy given the fact that we have always been subject to fiat currency, which is counted as money because of legal declaration.

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