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Mr. Wynand
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Would this happen under a free market and why or how?

I have been thinking about this very issue recently and have a few thoughts, though not an answer to your question.

The problem with fractional reserve banking in the 1800's seems to be that bank runs kept happening due to the low reserves kept. The 20th century answer in the US has been to create a banking oligopoly with the ability to create money at will. The results have been at least as terrible.

I think most of the problem could have been avoided with better disclosure and less fraud. The private bank notes, "redeemable for one ounce of gold from XYZ Bank" allowed the owner to believe that his money was stored in the vault and was his on demand, when that was not actually the case.

What I think might be a more proper fix would be to have two basic types of accounts. One would be a CD sort of situation where the money you put in is loaned out and is only redeemable at certain time intervals but earns interest. The other would be an account that was fully redeemable within a short period of time, where the gold was held in the bank. This two tiered system would allow banks to both loan money with a fractional reserve, since the withdrawals could be accurately predicted and at the same time, provide accounts with some sort of fee, which were truly payable on demand, since they would be required to keep the total account amount their.

As a side note, from 1900-1910, the number of banks in the US had doubled from 10,000 to 20,000 which would have probably put pressure on the industry to increase in quality and safety with regard to accounts. Also an increasing number of companies were funding their expansion out of profits rather than out of debt. I believe that, given enough time, the market would have corrected the over leveraged banks, but that is speculation, since we got the federal reserve banking cartel instead.

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There are already a bunch of threads on this topic. It's not going to be settled in a forum like this because proper understanding requires knowledge of a vast array of complicated pre-requisite subjects that are themselves unsettled and not commonly understood even by professionals.

FWIW, my own argument is that, yes, when people figure out what is really going on, free markets will move towards contractually secured full-reserve banking. Beyond that, please use the search function to read more, recognising that you're not going to get much satisfaction here.

JJM

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This issue is tied inextricably to the gold standard.

What's fradulent is: the illusion that the fiat money we have now is no different than actual gold (with certificates) and that a "deposit" in a bank is always fully redemable. The idea of "redemable" bank deposit with fiat money is rather absurd; you go to the bank and say "cash me out" and what do they give you? A piece of paper whose value is backed by the promise to tax future generations and whose exchange is forced: it is forced legal tender and companies are "not allowed" to refuse it. And moreover, with fractional reserve banking, if only a partial percentage of people went to cash out, the banks would "run out of ""money""" anyway. Insanity.

I personally believe the default moral method of certificate banking is gold, at full reserve. However, I have this 'other' thinking: couldn't a bank issue its own certificates and print right on them the disclaimer that the bank issues cerificates greater than their reserves? With that disclosure, isn't it then caveat emptor for a company or person to deposit gold in that bank? They know if a run comes, they are not guaranteed full cash out.

John Donohue

Pasadena, CA

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There are already a bunch of threads on this topic. It's not going to be settled in a forum like this because proper understanding requires knowledge of a vast array of complicated pre-requisite subjects that are themselves unsettled and not commonly understood even by professionals.

FWIW, my own argument is that, yes, when people figure out what is really going on, free markets will move towards contractually secured full-reserve banking. Beyond that, please use the search function to read more, recognising that you're not going to get much satisfaction here.

JJM

Do you know any books I could read on the subject that are of value?

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Do you know any books I could read on the subject that are of value?

Actually on the subject that say what I think is the right explanation as to why fractional reserve banking is dumb, no, not off the top of my head. As far as I can see (admittedly a somewhat limited literature review at present), all those in print opposed to FRB are out to waggle an angry (and wrong) finger about fraud and don't even slightly touch the real issue: FRB does not increase real maintainable capital beyond what would exist without the practice anyway (in fact it reduces it). The only reason why a bank in an LFC world could make a profit at it is because risk is being underpriced by its various customers. The practice of FRB will come to an end when a sufficient number of people finally figure that out, see that FRB contributes sweet FA to the economy, and so demand full-reserve accounts.

To get a handle on some of the prerequisites for figuring that out, look up why capital and interest exist at all and what they mean in physical terms... and on that note, start with Capital and Interest by Eugene von Bohm-Bawerk. Once you've got the physical meanings under your belt, look up the theory of the risk-return spectrum, from low-risk short-dated bills on through to speculative-grade debt and equity, as found in any decent graduate-level book on investment and portfolio theory (be warned that there are unwarranted conclusions in MPT - you'll have to sort out the good stuff from the bad yourself). Finally, read up on theory of sound bank management (eg the principle of duration-matching) and then tease out some of the unstated implications re FRB from what these books are saying: if you can figure out why the practice of FRB is not sui-generis but part of a whole class of questionable practices in bank management then you're well on your way. Again, any respectable graduate-level book on the matter would likely do, but also again you'll have to sort out good from bad.

Those three are the basics, and are enough for the intelligent to determine the rest on his or her own. I think you'll find it more worthwhile if you do all the legwork required and figure it out for yourself - it's not that hard, really, once you know what you're doing. There is one key to it all: remember that the physical world is paramount; always reduce every concept you use back to the physical world and see how these physical components interact in an integrated system. If you can stay true to that then with time and effort you'll get there. I stress this over and over and over, but it's always in-one-ear-out-the-other whenever I deal with people who see no problem with FRB.

JJM

Edited by John McVey
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Would this happen under a free market and why or how?

A "demand deposit" is "An account from which deposited funds can be withdrawn at any time without any notice to the depository institution" (Investopedia). It is a binding contractual relationship.

"Fractional reserve banking" is "A banking system in which only a fraction of bank deposits are backed by actual cash-on-hand and are available for withdrawal" (Investopedia).

"Fractional-reserve demand deposit" is a contradiction in terms. If a bank both operates with fractional reserves and offers demand deposits, it is defrauding it is depositors, because it has a contractual relationship with them that they may always withdraw their deposits at any time, but the bank knowingly and intentionally makes itself unable to honor its contractual relationships by doing other than keeping its depositors' deposits on hand or in safe keeping.

Serious, pervasive fraud has serious, pervasive consequences. When that fraud is made legal and takes the form of fractional reserve banking and demand deposits, then the consequences take the form of serious and pervasive bank runs and failures, and perhaps economic catastrophe.

In more practical terms, fractional reserve demand deposits looks like this:

Adam walks into Dollar Bank and deposits $10,000 into a demand deposit account. He receives a bank-note representing that $10,000. The note has a face value of $10,000, and is redeemable on demand for the deposited funds of $10,000. It fully and completely represents that $10,000. A may walk back into the bank at any time and surrender the bank-note for the $10,000 he deposited. Or, he may use the bank-note to buy goods or services, and the provider of these goods and services may at any time walk into the bank and surrender the bank-note, claiming the $10,000 deposited.

Bill walks into Dollar Bank and takes out a $10,000 loan, which Dollar Bank finances by using the $10,000 which Adam deposited into the bank. Now, Bill has the $10,000, and owes the bank the $10,000 - payable over the next ten years. But Dollar Bank does not have the $10,000 on hand to redeem the bank-note which the bank gave to Adam in exchange for the $10,000.

When Adam walks into the bank looking to redeem the bank-note for its face value, the bank will not be able to honor its contract with Adam. And the bank has made itself unable to honor its contract willfully and intentionally, and with full knowledge. The bank simply hopes Adam does not walk in and demand the $10,000 until Bill can pay it back, or that if Adam does walk in, he only demands at most $1,000 each year, which is what the bank expects Bill can pay back.

If Adam walks into the bank demanding $10,000, the bank will be forced to close its doors. It will have been exposed as a liar, a fraud and a cheat, and now it owes money to Adam which it gave away to Bill.

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I think you would have fractional reserve banking under a fully free economy with a full gold reserve.

I've argued against John McVey in the past on the issue, but I've come around to the conclusion that FRB has an inherent flaw: the premise that a collateralized asset can be valued at any particular quantity of money/gold.

FRB involves loaning deposited money out and accepting assets, such as real estate, as collateral protecting the value of the loans. The problem is that the collateral taken for any given loan can only safeguard against a borrower defaulting on that loan. It can not safeguard against the value of the collateral falling below the outstanding balance of the loan. Further, that aggregate collateral of all loans can not be balanced against the aggregate outstanding loans. A loan held by a bank is worth the lesser of the outstanding loan balance, or the value of the collateral. If any single loan goes into default with negative equity, the deficit must be made up from the aggregate interest earned by the bank.

The instability of FRB is exacerbated by the perception (created by the banks) that savings "deposits" maintain their value, regardless of the performance of loans. The loan process is transparent to depositors, so it is up to the individual to understand that he does not necessarily have a claim to the value of his deposit. The instability involves the process by which deposits are claimed when a (real or perceived) loss of loan value occurs; which is, first-come, first-served. The first to remove their deposits will receive full value. Those not quick enough will be offered to wait a period of time (specified in their depositors agreement, usually some multiple of 30 days) meant to allow the bank to raise their reserves by suspending loans as loan payments continue. Once the suspension is over, anyone still not receiving their deposit will be offered either to wait (without interest) for a lengthy liquidation process to retrieve some or all of their deposit, or will be offered by a third party a partial payment in return for the claim on their account.

If the run is due to perceived insolvency only, then the banks can do some things to stave off the panic until collateral values rise to safe levels again. These consist mainly of suspension of cash payments, in favor of account-to-account and bank-to-bank transfers, by check, wire or credit card. In this way you can continue using your deposited money for payment to anyone connected to your bank without having to withdraw cash. If collateral value doesn't rise, though, this tactic just delays the inevitable.

FRB in a fiat system has a relief valve, in the form of the printing press. If banks teeter on the edge of bankruptcy, they (or the gov't) can simply print money to inflate the currency, thus eventually increasing the price of collateral until it is in line with outstanding loans. That is precisely what the government is doing now. By increasing the federal debt from $10T to over $12T in less than a year, they are trying to cause general prices - and thus real estate values - to rise sharply. That's why "it doesn't matter" what we spend the "stimulus" on, as long as it increases the price of goods. And the the more we depress the output of our economy, that is, the more wasteful the spending is, the more effective the tactic is.

Under a gold standard you might still have FRB and interest-bearing deposit accounts, but there would be no "safety net" from the gov't, so people would have to understand the risks before they deposited, and not allow those risks to be assumed by everyone else.

Edited by agrippa1
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@agrippa1 A deposit account which is fractional reserve could not be a demand deposit account (see my previous post for definitions), except by fraud. That is, it could not be a checking or a savings account where you the depositor are able to take your money out at any time and for whatever reason. This is because the only way to guarantee the demand-ness of a deposit account is to ensure that the account is fully backed - that the deposited assets are there, not loaned out, available for withdrawal at any time per contractual agreement.

Other forms of investment are different. They are not demand deposit accounts. You don't get a written contract guaranteeing that you can take all of your money out at any time and for any reason. Other forms of investment would certainly exist. They would not be called savings accounts or checking accounts. They would be called certificates of deposit, investment accounts, securitized debts, funds, etc.

Fractional reserve banking is impossible in true laissez faire. Banks which engaged in it would not be able to survive. Moreover, it would be recognized as fraud - it is nothing more than double-counting your money and pretending you have $2 for every $1 you actually have - and would be banned by law.

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I see the topic has reared its head again in earnest :rolleyes:

I have no doubt that in the early days of the practice it was indeed naked fraud because the goldsmiths weren't doing what their deposit customers were paying them to do. Today, however, I doubt very much if there is anyone over the age of 18 who either doesn't know or is given plenty of evidence that they should ask what it is that banks do with the money in deposit accounts. In the UK, for instance, there is a famous legal case from the 19th century that dealt with this issue and came down on the side of the banks for that reason (I keep forgetting the citation, dammit). This case is still common law in the UK, and while no longer such in Commonwealth countries it is still held as "persuasive" in non-UK courts. From both a practical and legal point of view, there is no longer any fraud these days.

To be fraud, there has to be express expectation of certain things being done, either explicitly stated or as "standard practice" well-known enough to be held as such in common law of contract. True, for any given practice there is a big gulf between what is done occasionally (including secretly) on the one hand and what is common enough to be "standard" and expected to be known by customers on the other, but that gulf got crossed a looooong time ago re banks' lending out of "deposit" accounts: the practice is by far commonly enough known (evidence of which includes the constant reignition of this very debate and related issues) so that those who don't know what banks are doing are the odd ones out. So, the worst one could say about the use of the word "deposit" here is epistemological corruption - I certainly decry that (and I did so on this forum last year, somewhere), but epistemological decay is not the same as immorality.

Fractional reserve banking is to be addressed and refuted on epistemological and economic grounds. Ethical grounds do play into it, not in the anger-driven head-on manner that most opponents of the practice repeatedly resort to, but in regards to the exercise of rationality and pursuit of sound behaviour as appropriate to the context.

JJM

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@John McVey Yes, most people know what banks do with their deposits.

But a contract is a contract. It is impossible for the bank to honor its contract to provide its customers with demand deposit accounts, and at the same time engage in fractional-reserve banking. The bank promises one thing and does another. This is so whether or not its depositors are aware of the practice.

It is simply impossible for a bank to invest its depositors' money in illiquid long-term assets while, at the same time, promising its depositors that its deposits are as good as cash and that its depositors can withdraw any part or all of their money for any reason at any time. Therefore, whenever a bank promises this, it engages in fraud, because in fact the deposits are only as good as the illiquid, long-term assets which the bank purchased with them.

Most of the time, only a small fraction of the depositors want their money out. But in a fractional-reserve bank with a reserve ratio of 10%, the moment 10% of the bank's depositors want their money out, the bank is ruined. Sure, the bank might borrow from another bank, and so stave off financial disaster. But the moment 10% of the country's depositors want their money out, all of the country's banks are ruined.

This practice is, in whole or in large part, the cause of many of the downturns and economic crises in American history - most notoriously the Great Depression. This happens because fractional-reserve banking is a giant fraud, and, sooner or later, giant frauds of necessity come crashing down.

I am not arguing that, from a highfalutin ethical standpoint, it is fraud - but from a concrete, practical standpoint, there are no consequences. On the contrary - the moral is the practical. The practice of fractional-reserve banking is the culprit in may economic crises throughout American history. It is the culprit behind many Americans losing all their life savings, simply because others got lucky enough to get their money out first. Morally, it is widespread fraud, and practically, it is economic catastrophe. This is so whether or not the practice is widely known.

The practice is widely tolerated today, in large part, because depositors believe the government will bail them out if their deposits are in trouble, through FDIC if their banks go under, through bank-bailout packages if their banks are in trouble, through TARP, through fiscal stimulus, etc. Fractional-reserve banking is backed by the full faith and credit of the United States, and its power to do violence to its own people.

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The only reason why a bank in an LFC world could make a profit at it is because risk is being underpriced by its various customers.
Risk is being underpriced? How so?

A "demand deposit" is "An account from which deposited funds can be withdrawn at any time without any notice to the depository institution" (Investopedia). It is a binding contractual relationship.

"Fractional-reserve demand deposit" is a contradiction in terms. If a bank both operates with fractional reserves and offers demand deposits, it is defrauding it is depositors, because it has a contractual relationship with them that they may always withdraw their deposits at any time

Other forms of investment are different. They are not demand deposit accounts. You don't get a written contract guaranteeing that you can take all of your money out at any time and for any reason.
I don't see the contradiction. What written contract do you get with bank accounts? I can't recall having a contract with any of my banks that guaranteed that I would be able to get all of my deposits at all times of my choosing.
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@John McVey Yes, most people know what banks do with their deposits.

But a contract is a contract. It is impossible for the bank to honor its contract to provide its customers with demand deposit accounts, and at the same time engage in fractional-reserve banking. The bank promises one thing and does another. This is so whether or not its depositors are aware of the practice.

It is simply impossible for a bank to invest its depositors' money in illiquid long-term assets while, at the same time, promising its depositors that its deposits are as good as cash and that its depositors can withdraw any part or all of their money for any reason at any time. Therefore, whenever a bank promises this, it engages in fraud, because in fact the deposits are only as good as the illiquid, long-term assets which the bank purchased with them.

...

If the depositors are aware of the practice, it is not fraud.

Infantile expectation is not the standard for fraud, either.

Read the fine print.

Punk said it best:

We already have it.

It is called a "safety deposit box".

You can get one at the post office.

Take all your money, put it in the box, and lock it.

A variation on this for the traditionally minded immigrant is called a "mattress".

Edited by Old Toad
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The practical effects of fractional reserve banking are horrendous. Bank run after bank run, economic crisis after economic crisis. In all cases, it is only the initiation of the use of physical force (or the threat of it, or fraud, or the threat of it) that brings about economic crisis. Free people, who are free from force and fraud initiated against them, do not turn their economies into train wrecks. The evidence is in favor of fractional reserve banking being a form of fraud.

Depositors are often aware of the practice. I wonder that they could ever endorse it of their own accord. Nevertheless, they endorse it when they are taxed and when they are given free deposit account insurance, when they know the banks will be bailed out if they engage in fraud, when the banks are required by law or regulation to engage in fraud, etc. The issue is not that people are not aware of what's going on. It is that they have voted to sever the connection between cause and consequence. They have voted to legalize fraud. They have voted in the FDIC. They have voted in bailouts. When the connection between cause and consequence is restored, fractional reserve banking will not be possible.

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The practical effects of fractional reserve banking are horrendous. ...

Virtually all bank-deposit-account services have always been and always will be based on fractional reserve banking. It is probably the essential and defining function of "banking." Without it, there is no "bank."

Depositors are often aware of the practice. I wonder that they could ever endorse it of their own accord.

People used banks before the Federal Reserve, the FDIC, regulations, and government bailouts. Anyone can avoid keeping his money a bank deposit account by using a safety deposit box or his mattress.

The problem with the current banking system is the government interferences you mention, not fractional reserve banking.

When the connection between cause and consequence is restored, fractional reserve banking will not be possible.

The "Mulligan Bank" in Atlas Shrugged was a fractional reserve bank.

Edited by Old Toad
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The "Mulligan Bank" in Atlas Shrugged was a fractional reserve bank.

What evidence do you have of this, especially once Midas opened a bank in Galt's Gulch? Remember, in the Utopia of Greed they used real gold for money, not paper bills, and in fact rejected that Dagny had any real money at all. In Galt's Gulch, Dagny was penniless because she didn't have any gold with her, and because they would not accept fiat paper money from her.

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Risk is being underpriced? How so?

For all the reasons that y feldblum raises as practical objections. The practice is actually a negative-sum game, where the risk to the economy is not compensated for elsewhere in the economy in any form at all. Still, there are still people who think there's nothing wrong with it. For them, the practice is merely taken "too far" today and that in an LFC world without a central bank backing up unsound banks it would be much more moderate. They cite the considerably higher reserve fractions prevalent in the 19th century, point out the non-existence of fraud in the proper sense of the word, have no objection in principle to the practice, and otherwise leave it at that. They are underpricing risk because they don't see that the practice is fundamentally worthless, and don't look into the economic details (which are daunting to the non-economistically minded). If they did that and assessed the risk properly they'd demand higher rates of return on the accounts (if they'd use them at all), and if risk were properly calculated the required rates of return would end up being higher than the returns the bank earns on the funds it lends back out again.

JJM

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It is simply impossible for a bank to invest its depositors' money in illiquid long-term assets while, at the same time, promising its depositors that its deposits are as good as cash and that its depositors can withdraw any part or all of their money for any reason at any time. Therefore, whenever a bank promises this, it engages in fraud, because in fact the deposits are only as good as the illiquid, long-term assets which the bank purchased with them.

As far as history and politics are concerned, you're not telling me anything I don't already know and you're preaching to the choir. There are no Objectivists who would dispute that central banking, fiat currency, and other interventions are evil practices necessarily having evil consequences. Focussing on those achieves nothing.

The real problem is that you haven't distinguished between unsound-if-excessive and unsound-in-principle, which is where the real debate among Objectivists lies. Leaving aside the references to consequences of intervention, what you have provided is concrete historal consequences of what could be claimed merely as excessiveness (which is precisely what many Objectivists do, even intelligent ones who have done some investigation into the matter such as Dr Binswanger), devoid of reference to integrating principles that would show that the practice is inherently unsound. Without the latter all you've got is a white-swans fallacy - and unlike its namesake is one that just happens to have a conclusion that is correct. You need the principles to prove the conclusion properly, and for that you need to refer to economics and what the relationship in real terms is between capital, interest, and the money supply, to demonstrate that the practice is negative sum.

If all you have is history then all you can offer in reason is a caution whose strength tends to vary with the history but which is never fully conclusive - and as it stands, all the history says is: avoid central banking and other intervention like the plague, but beyond that if you just take care to go easy and watch the rationality of your banker then you should be okay. Until you can show the economic principles you're just making yourself look like a rationalist on the matter.

JJM

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He made loans. You cannot do this without fractional reserve of some kind.

That's not true. He could have made loans either out of funds he and other stockholders invested as equity, plus out of longer-term debt instruments bought by other Gulch residents. IRL, for instance, you can make time deposits or buy CD's or any of a wide variety of other non-fractional products, where in turn the funding you provide is on-lent by the issuing bank. Mulligan merely needed to institute something like that in miniature if his own equity was insufficient and so still be a non-fractional bank.

Banking can indeed run full swing, with total efficiency-of-scale, without resort to fractional reserve banking. And yes, sorry Toad, but that still makes the institution a bank in the full sense of the word.

JJM

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That's not true. He could have made loans either out of funds he and other stockholders invested as equity, plus out of longer-term debt instruments bought by other Gulch residents.

If you remember, all of the residents of Galt's Gulch converted a lot of their assets to gold before moving there; and Midas had a lot of gold. In essence, at least at the beginning, he would be loaning out his own gold, for a price in gold (or other real assets). And they were all business minded, so they were all interested in making a profit (in gold or other real assets). And remember, most of the residents got some gold back because Ragnar raided government shipments of gold that was taken by force and returned their income taxes to them in gold. So, there was a lot of gold in the valley and a lot of productive men and women in the valley. Even something as seemingly minor, such as farming, would generate gold when the farmed items were sold in the valley. There could have been and was an actual gold based economy going on in Galt's Gulch.

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Speaking of banking, here is an interesting story about the government strong arming banks to change contractual agreements when it comes to home mortgages. All of the people mentioned in that article took out mortgages they couldn't really afford at 100% on the premise that they could refinance in a few years, but the housing market started to go down and they couldn't refinance as their variable rates kicked in higher than they could afford to pay. I don't understand why this is the banker's fault, since, as of course, it isn't; and the homeowners knew they couldn't afford the higher rates but signed the contract anyhow. I think it would be this sort of moralizing against bankers that would have led Midas to shrug and create Galt's Gulch, which is why I mention it here. Part of the functioning of banks under capitalism is that the government would stay out of private contracts mutually agreed upon by all involved, unless force or fraud were used to get the contract signed.

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That's not true. He could have made loans either out of funds he and other stockholders invested as equity, plus out of longer-term debt instruments bought by other Gulch residents. IRL, for instance, you can make time deposits or buy CD's or any of a wide variety of other non-fractional products, where in turn the funding you provide is on-lent by the issuing bank. Mulligan merely needed to institute something like that in miniature if his own equity was insufficient and so still be a non-fractional bank.

Banking can indeed run full swing, with total efficiency-of-scale, without resort to fractional reserve banking. And yes, sorry Toad, but that still makes the institution a bank in the full sense of the word.

JJM

Sorry, John, but that is not a well-accepted defintion of "bank," but rather of a brokerage house or some other kind of investment firm.

A "bank" (in this sense) is characterized as follows: "a financial institution that accepts deposits and channels the money into lending activities."

See, e.g.:

http://www.bankingterms.biz/define-bank/

http://www.glossary.com/dictionary.php?q=Bank

http://www.thefreedictionary.com/depositor...ial+institution

http://www.answers.com/topic/depository-fi...banking-company

From Ayn Rand, in her usual strong language:

Nobody but a moron could really believe that the money involved in a bank loan belongs to the banker; that he refuses loans out of personal heartlessness, and that he ought to hand out the money not on the basis of his depositors' security but on the basis of the applicant's need. If some banker took the admonition of this picture seriously, who would suffer most and lose their life-savings but the very people that the Leftists love to cry over—the small depositors, the widows and orphans? [This idea was later dramatized by the character of Eugene Lawson in Atlas Shrugged.]
--Ayn Rand, The Journals of Ayn Rand, 10 - Communism And HUAC (emphasis added).

Also, from Atlas Shrugged:

Seven years ago, Midas Mulligan had vanished. He left his home one morning and was never heard from again. On the next day, the depositors of the Mulligan Bank in Chicago received notices requesting that they withdraw their funds, because the bank was closing. In the investigations that followed, it was learned that Mulligan had planned the closing in advance and in minute detail; his employees were merely carrying out his instructions. It was the most orderly run on a bank that the country ever witnessed. Every depositor received his money down to the last fraction of interest due. All of the bank's assets had been sold piecemeal to various financial institutions. When the books were balanced, it was found that they balanced perfectly, to the penny; nothing was left over; the Mulligan Bank had been wiped out.

"Dr. Akston quit on the principle of sound banking," said Midas Mulligan. "I quit on the principle of love. Love is the ultimate form of recognition one grants to superlative values. It was the Hunsacker case that made me quit—that case when a court of law ordered that I honor, as first right to my depositors' funds, the demand of those who would offer proof that they had no right to demand it. I was ordered to hand out money earned by men, to a worthless rotter whose only claim consisted of his inability to earn it. ...."
(Emphasis added.)

The "Mulligan Bank" in Atlas Shrugged, as a "bank," loaned depositors' funds.

Edited by Old Toad
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That's not true. He could have made loans either out of funds he and other stockholders invested as equity, plus out of longer-term debt instruments bought by other Gulch residents. IRL, for instance, you can make time deposits or buy CD's or any of a wide variety of other non-fractional products, where in turn the funding you provide is on-lent by the issuing bank. Mulligan merely needed to institute something like that in miniature if his own equity was insufficient and so still be a non-fractional bank.

Banking can indeed run full swing, with total efficiency-of-scale, without resort to fractional reserve banking. And yes, sorry Toad, but that still makes the institution a bank in the full sense of the word.

JJM

Here you go astray... A CD is a dollar valued instrument backed by loans, backed by collateral, just like an FRB account. The issue is fundamentally the same as with FRB, with the exception that there is no pooling of a small fraction of deposits that can be used by the depositors to take care of day-day expenses. If the loans go into default, and the collateral backing those loans lose value to below the outstanding loan balance, then the Certificate of Deposit is in default as well. The only thing a bank gains with CD's is the ability to plan on delays in liquidation. In fact, FRB savings accounts are more properly flexible CD's, in that, in most cases the bank can honor an immediate demand for payment, but it holds the right (by agreement) to withhold payment for a period of 60 days.

Don't mean to jump on that point so hard, but the fundamental flaw in FRB, time deposits and CD's is that the value of the deposit in each case is assumed to be tied to its deposited dollar value (plus int), when in fact, its value is tied to the now-underlying asset backing the deposit, which is the borrowers' good faith and collateral backing the bank's loans.

FRB is just as viable as CD's and time deposits, as long as certain adjustments to the system are made. First and foremost, depositors must be made to understand that the value of their deposit is safeguarded, but not absolutely protected, by sound banking principles, including rigorous loan standards and adequate reserves. Second, transparency into bank statistics, such as amount of deposits, loans, reserves, default & late pmt rates, etc., would allow for open, market based evaluation of interest paid v. risk.

Mechanisms would probably need to be put in place to avoid the instability brought on by potential bank runs. One possibility is to allow for withdrawals only up to a percentage that represents the ratio of liquifiable collateral to total deposits. That is, if collateral has fallen to 99% of deposits, the bank might only allow for something less, say, 95% withdrawal of funds. The margin would assure depositors that in case of an overall default, the last man out would be no worse off than the first. In a full default the first man would lose 5%, but if the bank recovered, he'd get all his money back.

FRB provides the ability for individuals to pool their savings (delayed consumption) with their investment (payment for future production) in one account, and given the average cash requirements over time, pool a small amount of cash for day-day expenses, and for individual emergencies. The trade off is that a fraction of their deposit is not earning interest as loans, but they will have access to all of their wealth at (most) any given time. For most people this is a valuable flexibility. For example, if someone would normally put half their money into savings, and half into interest-bearing instruments, the overall interest they earn is (0.5i), and their access is limited to 1/2 of their wealth. In FRB, their interest is (1-frac)i, and they have access to 100%. If the fraction is 20%, they earn 80% more interest, and have 100% more access to their money.

That's a good trade, and it's worth some risk, as long as that risk is managed.

(edti: math :lol:)

Edited by agrippa1
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