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

Would loaning out depositor's money make it necessarily a fractional reserve bank? As Agrippa points out, so long as the depositor knows that his money is being used by the bank, then the bank can consider those deposits as the assets of the bank until that money is withdrawn. The bank usually pays interest on such deposits (such as savings accounts or other interest baring deposits), but it can only do this if the bank makes more interest by loaning out money. In other words, the agreement between the bank and the depositor is that the bank can use the depositor's money so long as that use of the money is paid for and the depositor agrees that he cannot withdrawal everything at a moment's notice. In this sense, the bank is not loaning out more money than it has access to, so it would not be fractional reserve banking in the sense of handing out more money than deposits and letting depositors take out their money at will. For something like a savings account or other high interest baring deposits, there is usually a penalty for early withdrawal, so the bank is saying, in effect, you agree to let us use your money, so don't expect it back any time soon without losing the interest and perhaps a penalty for disrupting the banking practice. People like to say it is my money in the bank, but by putting it into a bank you agree to let the bank use it, and you cannot have that money at the same time the bank has it.

What I am against is the bank loaning out more money than it has or that it has access to in the above description. In other words, say the bank has a billion dollars in the combination of it's own money and depositor's money that they can use, and then they print out claims to the amount of 2 billion dollars, which they don't have or have access to.

So, I don't know, maybe I am confusing fractional reserve banking with printed money backed by assets, and then printing out more money than one has assets to back it up. But as has been outlined, I don't consider loaning out depositor's money immoral or fraudulent so long as the depositor has agreed ahead of time that the bank can use that money to make more money. In this sense, it would be like you agreeing to let your neighbor borrow your lawn mower for a price; but you couldn't use the lawn mower at the same time your neighbor was using it. The lawn mower is still yours, but you have an agreement as to when it was going to be used and by whom. Likewise with a bank; yes, it is your money, but you have agreed that the bank can use it, and you cannot have it to spend while the bank is using it.

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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.

...

The only thing a bank gains with CD's is the ability to plan on delays in liquidation.

You're missing what makes FRB as fractional - that 'only' thing is almost the whole trick, and makes all the difference in the world. With a fractional account, the bank lends the physical funds at the same time as the customer being able to make non-physical transactions directly against the numerical contents of the account. They are called fractional because only a fraction of the numerical contents are kept aside for immediate payment on demand. That doesn't apply to time deposits and CD's etc because they are not subject to the contractual requirement of immediate payment - cashing them in prior to maturity is a sale, not a withdrawal.

All the detail about the commercial risk in the physical lending is of no consequence to the issue of whether a given instrument is fractional or not. Discussion of what backs them and what their values are is only of importance when dealing with the issue of whether FRB has any merit.

FRB is just as viable as CD's and time deposits, as long as certain adjustments to the system are made.

While keeping the practice to a minimum can mean there is little problem of stability, there is no way to make FRB a net contributor to the economy. I'm not going over all that again, I've explained it in detail (admittedly not all that well in places) elsewhere.

Would loaning out depositor's money make it necessarily a fractional reserve bank?

That depends on the actual nature of the account. If the customer can issue checks, withdraw cash from an ATM or branch teller's window, and do direct deposits in and out of it etc, all directly changing the numerical contents of the account, then that account will be fractional if the bank lends out so much as a single cent from it.

JJM

Edited by John McVey
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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.

What you've shown is an example of the epistemological corruption I was talking about. The modern equivocation on the meaning of the word "deposit" has become so widespread and entrenched that it isn't even fraud in the full legal sense to knowingly make use of that equivocation. All the links you provide are modern definitions - based on non-essentials - that have arisen well after the corruption took place (and subsequently enshrined in bank licencing law). And, I am sorry to say, it looks as though Miss Rand is a victim of it, too. Happily enough, however, it doesn't change Midas' point.

Here's how to define a bank properly. A bank is to be distinguished from other financial institutions, such as insurance companies, stockbrokers, or cheque-cashing operations, so the genus is "financial institution." What distinguishes a bank(*) from the others is that its products are cash-handling and payments-systems services, as opposed to other financial products. Those services include coin minting and assay, note issue, deposit accounts of various kinds, cheque accounts, ATM access, currency exchange (the source of the word 'bank' itself and who were the people that Jesus booted out of the Temple), and so on. Not one iota of that requires that the bank lend out of any of the funds in those accounts or issue more notes than coins held in vaults. You can have a bank today put a halt to the practice and it will still be a bank because the true differentia remains: its financial product is systems and services that make cash-handing and making payments easier for their customers.

It is this focus on cash services for customer convenience that separates a true bank from a money-lender as well as other financial instutions. That a bank may also engage in money lending, whether from its own equity or longer-term debt bought by customers, and use the same branches as used by its banking activities proper to achieve operational efficiencies thereby, is beside the point.

A bank is a financial institution that provides services to provide customers more convenient means of receiving, exchanging, storing and paying money, through the provision of either accounts denominated in money or tokens redeemable in money.

A bank practices fractional reserve banking if there is less money physically set aside for payment against accounts or tokens than the total numerical amount held in accounts or tokens outstanding. Whether a bank does this or not has no bearing on its status as a bank.

(*) A bank under this definition includes credit unions. As far as I can tell so far, the difference was originally class-based nonsense - my own banking textbook explicitly says that the term 'bank' is denied to credit unions because it has a certain cachet that is to be denied to them for some unexplained reason - and later one of licencing, ownership structure and law that kept up the class-based habits. For instance, banks are now legally required to be corporations with a certain minimum of assets, while CU's are member associations with a minimum of 25 members. I see no real justification in retaining this distinction and the laws that maintain it. I *think* S&L's are in the same boat.

----

On top of all this, I constantly see floating about the idea that a bank that does not practice fractional reserves cannot make loans. This is completely untrue. All that the avoidance of the practice means is that accounts subject to payment on demand aren't lent out of, but there are plenty of other sources that a bank has recourse to. The bank's own cash as originally invested by the stockholders of both ordinary and preferred stock is an example from equity sources. Time "deposits" and certificates of "deposit" are examples from non-equity sources, but so also are issues of commercial notes, normal bonds, units in cash management trusts, and so on. In fact, the last time I looked at the statistics for finance in Australia (as it stood some time last year) I found that non-fractional sources outweighed fractional sources of loanable funds by a whopping seven to one. The implicit idea that the non-use of FRB would mean economic contraction through businesses being starved of debt funding needs to be thrown out root and branch.

JJM

Edited by John McVey
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What you've shown is an example of the epistemological corruption I was talking about. The modern equivocation on the meaning of the word "deposit" has become so widespread and entrenched that it isn't even fraud in the full legal sense to knowingly make use of that equivocation. All the links you provide are modern definitions - based on non-essentials - that have arisen well after the corruption took place (and subsequently enshrined in bank licencing law). And, I am sorry to say, it looks as though Miss Rand is a victim of it, too. Happily enough, however, it doesn't change Midas' point.

Classic Encyclopedia

Based on the 11th Edition of the Encyclopedia Britanica published in 1911

The manner in which a bank prospers is explained by David Ricardo [(1772-1823), English economist] in his Proposals for an Economical and Secure Currency [1819], in a passage where he tells us that a bank would never Banking be established if it obtained no other profits but those 'a ' derived from the employment of its own capital. The real advantage of a bank to the community it serves commences only when it employs the capital of others. The money which a bank controls in the form of the deposits which it receives and sometimes of the notes which it issues, is loaned out by it again to those who desire to borrow and can show that they may be trusted. A bank, in order to carry on business successfully, must possess a sufficient capital of its own to give it the standing which will enable it to collect capital belonging to others. But this it does not hoard. It only holds the funds with which it is entrusted till it can use them, and the use is found in the advances that it makes. Some of the deposits merely lie with the bank till the customer draws what he requires for his ordinary everyday wants. Some, the greater part by far, of the deposits enable the bank to make advances to men who employ the funds with which they are entrusted in reproductive industry, that is to say, in a manner which not only brings back a greater value than the amount originally lent to them, but assists the business development of the country by setting on foot and maintaining enterprises of a profitable description. It is possible that some part may be employed in loans required through extravagance on the part of the borrower, but these can only be a small proportion of the whole, as it is only through reproductive industry that the capital advanced by a banker can really be replaced. A loan sometimes, it is true, is repaid from the proceeds of the sale of a security, but this only means a transfer of capital from one hand to another; money that is not transferred in this way must be made by its owner. Granted that the security is complete, there is only one absolute rule as to loans if a bank desires to conduct its business on safe lines, that the advance should not be of fixed but of floating capital. Nothing seems simpler than such a business, but no business requires closer attention or more strong sense and prudence in its conduct. In other ways also, besides making loans, a well conducted bank is of much service to the business prosperity of a country, as for example by providing facilities for the ready transmission of money from those who owe money to those to whom it is due. This is particularly obvious when the debtor lives in one town or district and the creditor in another at a considerable distance, but the convenience is very great under any circumstances. Where an easy method of transmission of cash does not exist, we become aware that a " rate of exchange " exists as truly between one place and another in the same country as between two places in different countries. The assistance that banking gives to the industries of a community, apart from these facilities, is constant and most valuable.

...

(This is a rather lengthy article discussing the history of banks and banking over prior centuries.)

http://www.1911encyclopedia.org/Banks_and_banking

I trust this historical example from 100 years ago, including discussion of the nature of "banking" from a source that is now nearly 200 years old, is sufficiently historical. The word "bank" is not "an epistemological corruption" or a "modern equivocation on the meaning of the word 'deposit' or "modern definitions - based on non-essentials - that have arisen well after the corruption took place (and subsequently enshrined in bank licencing law)."

You may quarrel with the need of a "bank," but, respectfully, I think you need to check your understanding of the words "bank" and "banking" and "deposit accounts" so we can communicate better.

Edited by Old Toad
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You may quarrel with the need of a "bank," but, respectfully, I think you need to check your understanding of the words "bank" and "banking" and "deposit accounts" so we can communicate better.

I'm not going to quibble with that EB1911 article at all. It's actually saying precisely what I said: a bank's primary role, which is what makes a bank a bank, is its relation to customers' use of money, with lending being something that comes later. It is only Ricardo, quoted at the start of the article, who reverses the priority. My quibble over epistemology starts around about his time.

What the article begins with is pointing out the difference between exchange banks and deposits banks. This distinction matches (in reverse) my statement of banks' meaning being their relation to making monetary transactions easier either by use of accounts or the issue of tokens (primarily, but not exclusively, in the form of notes).

Exchange banks were those that took in coin or bullion and issued redeemable notes. They earned money from the fees they charged for the service. Consider the first example of a modern bank, that of Amsterdam from 1606, which the article expressly states whose purpose was making it easier for Dutch traders to use a standardised medium of exchange for local and international trade. It later made loans, which you will note were in violation of its own regulations for full-reserves for its notes, which (as I'm sure y feldblum will rightly note) ended up being the death of the bank. The same paragraph also mentions other local banks (such as that of Hamburg), again giving express attention to their role in facilitating trade that used money.

Deposit banks are more self-explanatory, and unlike exchange banks they are still major institutions today. In history, this is when we start seeing the increasing organisation and sophistication of the goldsmiths and foreign exchange dealers whose customers have become accustomed to leaving monies in trust with them. Again, it wasn't until much later that the formal lending started, and IMSM the BoE was established by force to give a veneer of civilisation to what was theft by the crown. That is what got the practice of fractional reserves really rolling, and from there to the heated debate between the Banking School and the Currency School in the 19th century, and so on.

You will also note that the BoE was generally expected to have full reserves (just like the Amsterdam bank was) and had to apply to Parliament to do otherwise. It did so three times in the 19th century and which contributed to the heated debate. The debate and the BoE's actions culminated in Peel's Act, which tried to outlaw FRB. Yet the Bank of England had already been around for centuries by then, and other banks even longer, all well known as banks. The practice of FRB is not essential either to the practice of banking or the definition of banking. A bank can indeed be a bank without resorting to it, and will still be one if it stops resorting to it.

After that, the article goes into more modern times, where the bulk of the discussion of more and more government intervention and the birth of central banking. And, of course, the practice of FRB was well and truly normalised during this time - and also discusses the kind of history of crises that y feldblum mentioned. It also discusses other countries still, where the same story is told: the primary focus was money and transaction services and secondarily lending except when governments extracted loans at the point of a sword or gun or themselves set up banks for that purpose.

My complaint about the modern slapdash definitions remains valid.

JJM

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Hello John,

It did not occur to me that Old English was still used in Australia.

My parents tell me that I used to speak some Old English with the grandparents when we visited the Old World. Heck, I hear Grandpappy once took me to see the “Very First Deposit Bank of England.”

That was before the Frogs (now known as the “French”) invaded in 1066, though. The Battle of Hastings was a fiasco, I tell you. Then the damn Frogs imposed new government banking regulations, known as Frog Reserve Banking (“FRB”).

FRB is the banking system I grew up with. Since I have long since forgotten Old English, I guess we have a language barrier.

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You're missing what makes FRB as fractional - that 'only' thing is almost the whole trick, and makes all the difference in the world. With a fractional account, the bank lends the physical funds at the same time as the customer being able to make non-physical transactions directly against the numerical contents of the account. They are called fractional because only a fraction of the numerical contents are kept aside for immediate payment on demand. That doesn't apply to time deposits and CD's etc because they are not subject to the contractual requirement of immediate payment - cashing them in prior to maturity is a sale, not a withdrawal.

You missed that the "only" thing is not actually a difference, since the bank can deny access to the contents for a significant amount of time. You also imply by your answer that "maturity" of a CD and time deposit correlates to the maturity of the loans to which they are applied. That is simply not the case. Immediate payment of deposits is subject to conditions set in the depositors agreement. Similarly, "maturity" of a time deposit does not guarantee access to the money deposited.

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@John McVey: My point was that fractional-reserve banking, as such, has brought about a history of bank failures and economic catastrophe.

The practical results of a practice must be used in determining the moral status of that practice, because there is no dichotomy between what is good and what works.

This history has in popular economics not been attributed to fractional-reserve banking (the cause is often said to be "excesses" in modern explanations). Popular economics has been searching in panic for a solution to the cycle of boom and bust. They have not found the cause, but they have come up with innumerable government programs, of all kinds, to attempt to prevent or mitigate the busts. The cause in earlier American history has been fractional-reserve banking as the predominant form of fiat money and inflation; currently, the fiat money and inflation come in many forms, including fractional-reserve banking, central banking with the power to print fiat notes, and central banking with the power to print debt.

Fractional-reserve banking is inherently unsound, as I have explained previously, because it is a legalized form of breach of contract and fraud. It does not matter that all parties know it. The fraud is not in the deceit: it is in the willful breach of contract. To take an example, suppose Adam puts $100 into a demand deposit account with a fractional-reserve bank. The bank now has liquid assets of $100 and a liability to Adam of $100. Suppose now the bank lends the $90 to Bill; the bank now has $10 of liquid assets and a $100 liability to Adam. And it has promised to Adam (in contract) that he may withdraw all of his money at any time and for whatever reason. The bank has lied, and has committed fraud and breach of contract. In its contract for the demand deposit account, the bank have $100 in liquid assets on hand, for every $100 in demand deposits in accounts with the bank. Suppose Adam writes a check for groceries for $50. The bank cannot fill that check, and now the grocery store has been ripped off (it is not a party to the fraud). If due to swings in economic reality depositors in general decide to withdraw 15% of their demand deposits, every fractional-reserve bank in the country immediately must close its doors. This scenario has taken place numerous times throughout American history, with devastating consequences. Many hardworking, honest and thrifty people have lost their life savings, through no fault of their own. The monetary expansion of fractional-reserve banking fueled booms of unsustainable malinvestments; when their unsustainabiilty became painfully apparent, the destruction of depositors' wealth fueled the ensuing busts.

Fractional-reserve banking is a form of fiat money and inflation. Like other forms of fiat money and inflation: fiat notes, Treasury debts, Federal Reserve "Open Market Operations," etc., it is the cause of the business cycle: periods of non-productive "irrational exuberance" characterized by the growth of the money supply and significant malinvestment, followed by periods of recession, the destruction of large parts of the money supply, and the failures of these malinvestments.

@Old Toad: So what if Mulligan's bank in Atlas Shrugged were fractional-reserve?

Edited by y_feldblum
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Hello y,

I can see we are all probably at an impasse, but I have a few parting comments, which are constructively intended.

It does not matter that all parties know it. The fraud is not in the deceit: it is in the willful breach of contract. ...

The well-accepted, non-legalistic "modern English" definition of "fraud" is:

1 a: deceit , trickery ; specifically : intentional perversion of truth in order to induce another to part with something of value or to surrender a legal right b: an act of deceiving or misrepresenting : trick

2 a: a person who is not what he or she pretends to be : impostor ; also : one who defrauds : cheat b: one that is not what it seems or is represented to be

synonyms see deception, imposture

http://www.merriam-webster.com/dictionary/fraud

To say that the "fraud is not in the deceit" means it is not "fraud" at all.

There cannot be a "breach of contract," either, where all the parties act according to their mutual understandings of the contract -- even if you think the words “should” mean something else. If you don't like the contract terms, as everyone understands them–including you–don't put your money in a "demand deposit account" in a "bank." As Ayn Rand pointed out, we all know what the bank does with the money – it loans most of it out. A fraction is held in “reserve” to meet expectations for usual demand withdrawals.

By analogy, it seems you would complain that it must be a fraud and breach of contract to sell "grapefruit" because there is no "grape" in the fruit, even though everybody knows this.

Fractional-reserve banking is a form of fiat money and inflation. ...

This is a patently false statement and represents a massive confusion and misunderstanding regarding "fractional reserve banking." If this misunderstanding (by at least one of us) is not corrected, it will make any further discussion very difficult, if not impossible.

A "bank," as such, does not loan out more money that it has in equity and deposits. If it does, it is "bankrupt" or "insolvent." (The "Federal Reserve Bank" -- as a quasi governmental entity -- might be able to "print" or "create" fiat money -- I do not know for sure -- but that is not the function of a "bank," but an immoral governmental act.)

@Old Toad: So what if Mulligan's bank in Atlas Shrugged were fractional-reserve?

Because it illustrates the widely-accepted understanding of a "bank" and "banking" (i.e., "fractional reserve banking"), that it is not fraudulent, a breach of contract, the cause of fiat money or inflation, or immoral.

I would be glad to continue this discussion if we can use well-accepted definitions. If you don't like the well-accepted definitions of certain words, I suggest that you use other words that do express your meaning according to the well-accepted definitions.

Edited by Old Toad
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@Old Toad: Breach of contract is a form of fraud. A demand deposit entails a contractual guarantee on the part of the bank always to be liquid enough to return the depositor's money. Fractional-reserve banking places the bank in the awkward position of being liquid enough to return its depositors' money only some of the time, but not all the time. Lending out a depositor's money, while at the same time guaranteeing that the depositor's account is as good as the money deposited, is a lie. That is breach of contract, and therefore fraud. The depositor is not the one committing fraud, and although he knows that the bank is committing fraud, there is not much immediate reason for him to care - after all, most banks will be liquid enough most of the time, right? The depositor does not place himself in jeopardy: the bank places him in jeopardy and is responsible for it. That the depositor knows what's going on does not change the bank's commission of fraud, in the form of breach of contract.

Fractional-reserve banking is fiat money and inflation, since credit is created out of thin air. The bank deposit remains tradable as money (since that is what the bank's guarantee amounts to), but now the money is also loaned out to a third party who can trade it as well. So with $100 deposited in a demand deposit account, that $100 remains in the money supply, but now $90 is added to the money supply out of thin air. In a world devoid of fraud, if the money is lent, then only $10 of the depositor's account could be used as money, since that is all that is actually in his account.

The widely-accepted notion of "bank" as "a safe place to put your money" contradicts the widely-accepted notion of "bank" as "an institution which specializes in lending other people's money." Although today banks are seen as both, they are not in fact both. They are one or the other.

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@Old Toad: Breach of contract is a form of fraud. A demand deposit entails a contractual guarantee on the part of the bank always to be liquid enough to return the depositor's money.
Doesn't your example assume that the depositor is aware of what is going on, and agrees to the arrangement? If so, how can you say that the arrangement that the depositor agrees to is in breach of that which he agrees to?
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Hello y,

In a world devoid of objective, well-accepted definitions, I agree, anything can be "fraud," even honoring a contract and grapefruit.

Regarding "credit created out of thin air," you reveal that you are unaware that accounting takes into account both sides of any transaction. You only count one side of each transaction, and then cry "fraud," "inflation," etc.

When you "deposit" $100 into a bank account, the bank makes TWO balanced accounting entries: (1) That it owes you $100; (2) that it has $100 in cash assets.

When the bank loans $90 of that money to another person, it makes TWO balanced accounting entries: (1) It subtracts the loan amount of $90 from its cash; (2) it adds that it is owed $90 by the other person as an asset.

The bank then has this accounting result: a) $100 in "liability" to you, its depositor; and b ) $100 in "assets."

Of course, the assets are: (i) $90 in money it is owed by the other person, which is expected to be paid back; and (ii) the $10 is cash reserve against demands for withdrawal.

The net change of "money supply" in every one of such transactions is always ZERO. No fiat money is created. No inflation is created.

The illustration of "Mulligan's Bank" in Atlas Shrugged didn't have those evils, either.

Banking (i.e., fractional reserve banking) worked before with gold standard currency and it would work again with gold standard currency.

The "safety" of the deposits and the "risk" of the loans must be managed, of course. The bank charges interest for the risk. The interest should cover the risk, actual losses, operating expenses, and profit. The bank should take much less risk with depositor's funds than it's manager might take with his own funds, because the depositors expectations of repayment are high--but only a child would expect 100% safety for this. In exchange for this risk, the depositor receives cheap and relatively safe "demand deposit account" services and other related transactional services (check cashing, wire transfer, etc., the like of which other non-bank entities may offer, too, such as "Western Union" or "Cash America" and the Post Office do for a fee or percentage), and for larger accounts, even interest, too. The bank is usually paid back the $90 loans, plus interest, and keeps the difference, after loan losses and operating expenses, as profit. This is where balanced accounting entries for income and expenses come in.

The bank aggregates the depositors' accounts to spread the risk and increase overall safety. The bank aggregates the loans to others to spread the risk and increase overall chances of repayment. On balance, and in general, it is managed to be very safe. On top of this, in a free society, the banks could buy insurance or come together and make mutual insurance, too. That would cut profits, but help attract depositors.

If a depositor desires higher safety than the bank normally offers on "demand deposit accounts," he should keep his money in a "safety-deposit box." This generates no income, is still subject to risk of bank heist, and has a maintenance fee that is probably not covered or subsidized by the bank's lending operations, except perhaps as a courtesy or incentive for sufficiently-large depositors in the "demand deposit accounts" and CDs, etc.

Preferably, a fractional-reserve bank is managed by someone like “Midas Mulligan.” If you don't want to "risk" the relative "safety" and convenience of a bank "demand deposit account," use a safety deposit box or your mattress. No one is stopping you, and that does not cause fiat currency or inflation, either.

The cry for the safety of "full-reserve banking" is the cry for the simplicity of the ox-cart instead of the complexity of the passenger jet. But which is really "safer"?

I become increasingly convinced that this discussion is at an impasse.

Edited by Old Toad
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I become increasingly convinced that this discussion is at an impasse.

I agree, until people can convince themselves that fractional commodity reserve and fractional reserve banking are two entirely separate concepts.

One thing I would add to your explanation of the bank's accounting is that the collateral behind the money owned is on the bank's books until the loan is paid off, in the form of liens or mortgages. If the bank does a good job of evaluating worst case collateral value, it can avoid running into the situation where backing asset values fall below deposit totals, which is what we're going through now.

The problem with FRB is the worst case is always that the collateral value could drop to as low as zero.

I disagree with John McVey on the fractional part being the whole issue. Imagine a bank where deposits are not loaned out but simply stay put in the vault. The bank owner notices that never more than 5% of the total deposits are out at any time, so, to save storage space, security and insurance costs, he transfers 90% of his cash to a main branch in the nearest city, where the cost of holding is less. Then imagine that bank does the same thing, transferring 90% of its cash to even larger banks where storage costs are even less.

Now a run occurs on the local bank and the depositors find that their money isn't there. Breach of contract? No, the bank has in its agreement a stipulation that they can delay withdrawal by some amount of time. If all the local and regional banks face a run, it may take a while to get the cash from the main banks out to the local banks to allow people to withdraw. That is functionally a "fractional reserve bank" at the local level, but it is not an unsound nor an inherently fraudulent practice.

It is in the equating loan collateral to deposited cash that the claim of fraud can come into play. And that is the only real problem with FRB.

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Imagine a bank where deposits are not loaned out but simply stay put in the vault. The bank owner notices that never more than 5% of the total deposits are out at any time, so, to save storage space, security and insurance costs, he transfers 90% of his cash to a main branch in the nearest city, where the cost of holding is less. Then imagine that bank does the same thing, transferring 90% of its cash to even larger banks where storage costs are even less.

Now a run occurs on the local bank and the depositors find that their money isn't there. Breach of contract? No, the bank has in its agreement a stipulation that they can delay withdrawal by some amount of time. If all the local and regional banks face a run, it may take a while to get the cash from the main banks out to the local banks to allow people to withdraw. That is functionally a "fractional reserve bank" at the local level, but it is not an unsound nor an inherently fraudulent practice.

This is not fractional-reserve banking in any sense of the term. This is not even "local fractional-reserve" banking. The bank continues to hold full reserves, whether at the counter or warehoused. A demand deposit contract would specify a schedule of how much time the bank has to fill its depositors' requests for withdrawal, a schedule which permits the bank enough time to transfer any holdings from the warehouse to the counter. There is no breach of contract.

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It did not occur to me that Old English was still used in Australia.

What the hell, Todd? That was needlessly and disappointingly insulting. It was you who brought up ancient history with attempt to prove your point. All I did was demonstrate that you were mistaken and that your article shows that what I had to say actually goes all the way back to day dot - and in response you go do this??

The definition of a bank I gave is based on direct observation of banks and other financial institutions as exist today as well as in the past. I looked for myself to find what the genus and differentia are. That included noting that banks are distinguished not just from other financial institutions generally but also from non-bank lenders by virtue of that differentia. The banking system has always been, and today still is, centred on the money supply and making the use of that money more convenient. The practice of lending from demand deposits of money while depositor's backs are turned is essential neither to the operation of a bank nor to the definition of a bank, and nor to any other part of the economy whatever for that matter. Hell, Todd, I would have thought that someone who waded into this topic would have known very well that a critical issue in the fractional banking debate is what the practice does to the money supply.

Banking, to be banking rather than some other financial service, is about depositors' access to and transactions in money. Everything else that banks do today is tacked on either because it is operationally efficient to do so or because banks are juicy targets for demagogues' and governments' plans for other people's money.

FRB is the banking system I grew up with. Since I have long since forgotten Old English, I guess we have a language barrier.

I expected that an Objectivist who I presume is well versed enough to have read technical works such as ItOE would not collapse into unquestioned acceptance of others' definitions of key words, and would have instead done his own independent observation and thinking. I expected that such an Objectivist would know considerably better than to fall back on "It's been that way for as long as I can remember, ergo it has to be that way." This is especially acute when the words in question come from a field that he should know damn fine is rife with distortions created out of ignorance, erroneous ethical beliefs, and express desires to achieve various economic and political agendas rather than concern for the truth.

I don't give a damn what the current consensus is, I think for myself and I bloody well expect every other Objectivist to do likewise. If you want to dispute what I have said then please do so properly with reference to epistemological principles instead of doing what looks like a yokel opining from an up-turned cracker barrel and making insulting comments because someone departed from the prevailing orthodoxy.

JJM

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You missed that the "only" thing is not actually a difference, since the bank can deny access to the contents for a significant amount of time.

At this point, what y feldblum has to say about breach of contract is spot on. If the account is advertised as a demand deposit, then the money must be paid over immediately on demand or else the bank is either guilty of breach of contract, or, if the contract's fine print allows for such delays, guilty of false advertising. The fact that a law may allow such actions is merely grounds for condemning that law. Without that kind of law, a bank cannot escape its legal obligations get away with it.

As to CD's, it makes all the difference in the world because CD's are not part of the core money supply. They are capable of being added on later as supplementary components, which is technically legitimate because one can indeed settle a debt by passing title on a CD to the creditor who can in turn do likewise with another creditor, but I raise an eyebrow at CDs' inclusion because their trade like that is hardly a significant proportion of transactions even of those involving CD's. For practical purposes, the purchase of a CD does not increase the money supply and is a real increase in credit that will help the economy along, whereas making a deposit into a fractional account does increase the money supply and the lending from that account is mere credit-expansionism that will come to no good end.

You also imply by your answer that "maturity" of a CD and time deposit correlates to the maturity of the loans to which they are applied.

I never implied any such thing. I only noted that a cashing in prior to maturity was not the same as a withdrawal.

On the technical side of the particular topic you mention, it is duration that matters more than maturity (your use of quotes suggests you know this). It is this practice you mention - called duration gap, for those who don't know - that I had in mind when I said that the practice of FRB was not sui generis. I know very well that lending out for durations longer than as apply to one's sources of funding is unsound (eg S&L crisis in the late 80's and early 90's), whether this is in reference to fractional reserve banking or not. This is one of the things that would be learned by Mr Wynand if he did what I recommended and researched what was good and bad about management of financial institutions. I didn't mention it expressly before because I didn't want to get into complicated mathematical concepts on a mere forum - it's something for people to read and think about on their own time or learn in a proper educational environment.

JJM

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My point was that fractional-reserve banking, as such, has brought about a history of bank failures and economic catastrophe. The practical results of a practice must be used in determining the moral status of that practice, because there is no dichotomy between what is good and what works.

I don't dispute the connection between morality and practicality. The issue is of hierarchy, and I am saying that you are improperly reversing it from what it should be. One does not conclude it is immoral simply because every single instance so far (which is debatable) is impractical, because doing that is merely committing a white-swans fallacy. Properly, one demonstrates that the practice is inherently impratical because it violates a principle - and being fast and loose about the meaning of fraud is not an example of that kind of principle required.

Fractional-reserve banking is inherently unsound
I don't dispute that ...

because it is a legalized form of breach of contract and fraud.
... but I do dispute that.

It does not matter that all parties know it.

Yes it does. That is what changes the matter from an actual breach of contract to a mere potential one - also a crucial point in the abortion debate, incidentally. That change prevents the government from taking action against the practice except where there are express terms in any individual contract.

Everyone here is generally correct to dispute your use of the word "fraud." What you're describing is not fraud, plain and simple, and it is not helping you any to go on about it because that is precisely the sort of thing that Diana was right to object to as rationalism. The mere fact that there's a high chance that a bank might not be able to settle every single depositors' accounts all at once does not yet mean that the bank has in fact failed to abide by any separate contract with an individual depositor to pay that depositor. For all anyone knows the bank in question may have reinsurance arrangements, which can work perfectly well because the requisite funds can come in by the service entrance while big queues and attendant delays form out in front of the retail counters.

So, any given bank may well become the subject of a run, but no claim of fraud or breach of contract can be made until any one of those individual depositors is physically turned away because of a lack of funds in the tills, which thanks to its external arrangements might not happen even if the run goes full swing and will end the bank's deposit business. The potential for customers being turned away is not the same as this actually having happened. So, in the meantime there is no principle that says banks can't do their level best to calculate risks and act accordingly. Thus Toad is quite correct on this much (including what's in the ellipses):

The "safety" of the deposits and the "risk" of the loans must be managed, of course. The bank charges interest for the risk. The interest should cover the risk, actual losses, operating expenses, and profit.

...

The cry for the safety of "full-reserve banking" is the cry for the simplicity of the ox-cart instead of the complexity of the passenger jet. But which is really "safer"?

The only way out is exactly as I have stated: show that the practice is worthless because it adds nothing to the economy, and hence that the true value of the risk exceeds the value of the returns.

Fractional-reserve banking is a form of fiat money and inflation. Like other forms of fiat money and inflation: fiat notes, Treasury debts, Federal Reserve "Open Market Operations," etc., it is the cause of the business cycle: periods of non-productive "irrational exuberance" characterized by the growth of the money supply and significant malinvestment, followed by periods of recession, the destruction of large parts of the money supply, and the failures of these malinvestments.

Other than the calling of fiduciary media as necessarily fiat money, again, I have no dispute with that. What I am trying to tell you is that you have to prove this is the inherent result of FRB by reference to economic principles, because unlike what the Amsterdam bankers and London goldsmiths did in the 17th century there are no core ethical principles being directly violated these days. One cannot sit content with a simple "immoral, therefore impractical" on the FRB issue today.

JJM

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At this point, what y feldblum has to say about breach of contract is spot on. If the account is advertised as a demand deposit, then the money must be paid over immediately on demand or else the bank is either guilty of breach of contract, or, if the contract's fine print allows for such delays, guilty of false advertising.

Show me an advert from a bank that states that you have instant access to your deposits, and I'll concede that point.

Or are you claiming that the word "deposit" implies that claim?

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This is not fractional-reserve banking in any sense of the term. This is not even "local fractional-reserve" banking. The bank continues to hold full reserves, whether at the counter or warehoused. A demand deposit contract would specify a schedule of how much time the bank has to fill its depositors' requests for withdrawal, a schedule which permits the bank enough time to transfer any holdings from the warehouse to the counter. There is no breach of contract.

No, the bank holds only a fraction of the deposits, as well as an IOU for the amount of deposits held at the regional bank. I agree there is no breach of contract, but you are missing the point...

Okay, I'll make it easier for you:

Assume a gold standard. Imagine you deposit $100 in a bank. Next bloke comes along with $90 worth of gold, and the bank takes $90 of the dollars you deposited and gives them to him in exchange for his gold. The bank now has only 10% of the money you deposited. You can't get the $100, because they've exchanged 90% of it for an equivalent amount of gold. If you demand your full deposit, you will have to wait until the bank liquidates the $90 worth of gold before receiving your $100 deposit.'

The bank has practiced fractional reserve banking, with the deposits backed by gold, rather than loan collateral.

Fraud?

Get it? It's not that they have given out your money (under whatever terms) and are backing it with equivalent (or greater) assets. It's that the assets backing the deposits may decrease to below the dollar value of the deposits.

If you still disagree, then imagine the same scenario, but not under a gold standard.

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No, the bank holds only a fraction of the deposits, as well as an IOU for the amount of deposits held at the regional bank.

They are the same entity. Warehousing the depositor's money is not the same as lending it out, because the bank can always recover the deposits of every depositor at any time, within the time it takes to transport the money from the warehouse to the counter. The bank remains fully liquid the whole time. When the bank lends out its depositors' money, the bank becomes highly illiquid and must hope against hope that not too many depositors at any time want access to their deposits, for fear of going bankrupt.

Assume a gold standard. Imagine you deposit $100 in a bank. Next bloke comes along with $90 worth of gold, and the bank takes $90 of the dollars you deposited and gives them to him in exchange for his gold.

What gold standard are you talking about? Is gold money or isn't it?

The bank now has only 10% of the money you deposited. You can't get the $100, because they've exchanged 90% of it for an equivalent amount of gold. If you demand your full deposit, you will have to wait until the bank liquidates the $90 worth of gold before receiving your $100 deposit.'

The rest of this example seems not to make sense, because you are talking about gold as if it were not the actual money deposited at the bank.

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I don't dispute the connection between morality and practicality. The issue is of hierarchy, and I am saying that you are improperly reversing it from what it should be. One does not conclude it is immoral simply because every single instance so far (which is debatable) is impractical, because doing that is merely committing a white-swans fallacy. Properly, one demonstrates that the practice is inherently impratical because it violates a principle....

This - proof by principle - seems like rationalism. Properly, one demonstrates a proposition like this both by looking to the principles one already knows as well as to the concrete details of the proposition, to its causes and its effects.

I make two points:

First, that a fractional-reserve bank offering demand deposits makes its depositors a guarantee that the bank cannot keep, and - as a form of breach of contract, practiced on the widest of scales - such a practice must inevitably come crashing down. Lies multiply and frauds multiply, until they build up to a point where they can multiply no further. Then they come crashing down. The principle is: the virtue of honesty, and the impossibility of long-term dishonesty.

Second, this practice has in the past come crashing down every time it has been tried, perhaps most notoriously the banking and economic collapse of 1929. Since then, we have seen much less of a collapse in this particular form of credit expansion, because the US government has severed cause and effect by actively shifting the risk and punishment inherent in fractional-reserve banking onto other parts of the economy.

Yes it does. That is what changes the matter from an actual breach of contract to a mere potential one - also a crucial point in the abortion debate, incidentally. That change prevents the government from taking action against the practice except where there are express terms in any individual contract.

Correct, in that the specified terms in the contracts have not in themselves been breached. However, the bank has rendered itself impotent to honor its contracts in any except the most mild of economic circumstances. The moment 11% of its depositors wish to switch to another bank (supposing a 10% reserve), the bank is rendered broke. Furthermore, since fractional-reserve banking is a particular form of fiat money, the inflation is unsustainable and the fiat money will be destroyed. This happened in 1929, and the rapid destruction of fiat money of a different form is currently happening in 2009.

I would consider it to be fraud knowingly to put oneself in a circumstance where one will be forced to breach contract. This is what fractional-reserve banks do. The fiat money will be destroyed, because nature abhors a lie (especially a nationwide lie), and the moment the banking panic sets in, the fractional-reserve banks will have destroyed the life savings of 90% of their depositors.

Other than the calling of fiduciary media as necessarily fiat money, again, I have no dispute with that.

One can look at fractional-reserve banking in two ways: as credit expansion, and as false fiat banknotes.

As credit expansion: The loans which the bank originate with its depositors' money become a part of the money supply and represent new and additional money, because the borrower has physical possession of the money, while at the same time the depositor also has full right to physical possession of the money, and can exchange this right (in the form of a claim against a deposit) in daily economic activity.

As fiat banknotes: the actual money was loaned out, and now another person is trading with it. However, now the depositor is trading with a claim against that very same money, when he is not in possession of it. Most of the deposits can and will be destroyed the moment the fractional-reserve bubble bursts.

Fractional-reserve banking creates new loans, a form of money, where they could not otherwise have been created. However, since it is not the debt instruments which are traded, it is not the debt instruments which are destroyed when the bubble bursts and inflation is forcibly reversed. It is the deposits which are destroyed, and therefore the deposits can be seen as the false money as well. The loans are new and additional money, while the deposits are destructible money. (In the present economic collapse, the government protects deposits from their impending destruction, while trillions of dollars' worth of securitized debt instruments have been destroyed.)

Whichever way one looks at it, the only answer is a private, fully-backed commodity money system.

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Doesn't your example assume that the depositor is aware of what is going on, and agrees to the arrangement? If so, how can you say that the arrangement that the depositor agrees to is in breach of that which he agrees to?

The depositor agrees to the contract he signed, which he can attempt to enforce in court. It is, of course, his money which is held in reserves, while it is others' money which is loaned out.

Many depositors are under the illusion that the bank can safely invest the deposits and remain solvent over the long term, while at the same time providing on-demand access to the deposits. They are mistaken. Banks can do so over the short term, and then after the impending economic collapse and the destruction of the current banks, the next generation of banks will also be able to do so over the short term.

Many savvy investors invested with Bernard Madoff in a scheme which they knew was too good to be true (they didn't know what the scheme was). Fractional-reserve banking is also too good to be true.

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Show me an advert from a bank that states that you have instant access to your deposits, and I'll concede that point.

Every-day classic banking from National Australia Bank; "Unlimited banking how and where you want"; express statement of unlimited access in a variety of ways. Further, see terms 1.1 and 1.5 of this class of accounts' Terms and Conditions, which are legally binding on the bank.

Or are you claiming that the word "deposit" implies that claim?

Not the word deposit, the term demand deposit, or words to that effect (eg "unlimited access"). My complaint about the degeneracy of "deposit" is another issue entirely - which complaint included recognition that its use on its own nowadays does not constitute fraud when FRB is practiced.

But anyway, I don't see why you're making a fuss about this particular issue in this particular manner. The issue of fractional reserve banking doesn't apply to CD's for the reasons I've already stated (ie they are not part of the core money supply). The related issue of duration gap does link FRB with the broader issues of bank soundness in general, but that's a secondary matter.

Moreover, I am not the one claiming fraud, but quite the opposite! This is precisely the point I am trying to make to y feldblum. There are no grounds for a charge of fraud unless there is an explicit term of contract that is being actually breached, and no grounds for a related charge of false advertising unless the contract is contrary to what the advertising implies is in the contract. I was simply noting that there would be a breach of contract under the conditions you specified, not that it these conditions always exist (eg see footnote 3 on page 20) and not that it is always fraud. All that the NAB is saying, for instance, is that you'll have access to your money and where you want it, but even then some daily limits exist for internet transactions (per clause 17). So long as they comply with what they said they will do, and have expressly stated that they will pay depositors interest and hence clearly implying they're doing something other than letting the money gather dust in a vault, they are not guilty of breach of contract. Ergo, no fraud.

JJM

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Many depositors are under the illusion that the bank can safely invest the deposits and remain solvent over the long term, while at the same time providing on-demand access to the deposits. They are mistaken. Banks can do so over the short term, and then after the impending economic collapse and the destruction of the current banks, the next generation of banks will also be able to do so over the short term.
Good banks can definitely remain solvent over economic cycles. Historically, good US/UK banks did very little real-estate lending and very few long-term loans. They kept large reserves and many of their assets were very short-term.

Many savvy investors invested with Bernard Madoff in a scheme which they knew was too good to be true (they didn't know what the scheme was). Fractional-reserve banking is also too good to be true.
No, a ponzi scheme cannot work, by design. The same is not true of banks that keep less than 100% reserves.

Poor lending standards have been behind most downturns. Obviously, if banks keep 100% reserves and do not lend it out, then the lending standards cannot be relaxed by banks. i.e. if they don't lend, where's the question of standards. If banks don't lend, someone else will. All that will happen in such a situation is that other cash-like accounts will develop: like the many money-market funds of today. So, you'll get some 100% accounts and some non-100% accounts. People will likely keep some money in one type and some in the other.

Edited by softwareNerd
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@Software Nerd: I have no problem with banks lending. They should simply not be doing it out of demand deposit accounts. They can lend out of CD's, and they can even set up an investments department that lends out of funds which customers deposit to be invested. However, CD's and investment accounts are not demand deposits - they are not guaranteed to be safe or to represent the deposits.

When banks permit both borrowers and depositors to use the same deposited funds, that's when the problems start. This scheme cannot work. If this scheme is widespread, the only result can be a banking panic and an economic collapse.

Inflation has a tendency not to remain stable. It tends to accelerate as a bubble, until it is stopped. When it is stopped, a correction or a bust sets in. Fractional-reserve banking, like any kind of inflation, is not stable, and engenders booms and busts just like any other kind of credit expansion.

@John McVey: The fraud is in permitting depositors to treat their deposits as though they were as good as the money deposited, when in fact the deposits are not as good as the money deposited. The money deposited is not in the bank and cannot be withdrawn at will - it can only be withdrawn in "mild" economic seas, which are sure to turn choppy and get worse from there. So long as depositors in a demand deposit account are prevented from treating the account as a demand deposit account, by contract - by embedding a clause to the effect that the bank is permitted to renege on its obligation to return all the depositor's deposits to him - there is no fraud. Because, sans Federal bailouts, the bank will renege on its obligations.

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