full reserve banking

Economics
61

Doesn’t that, in and of itself, mean that fractional reserve banking is not fraud?

Ka-CHING!

I am utterly and implacably opposed to the practice - but I do not use the fraud argument because it does not hold a drop of water. My objection is economic.

I don’t understand this part. Suppose my banker invests some of my deposits in stocks. As we’re both benefiting, how is this a negative-sum game?

I haven’t explained it here, but have done so in detail in other threads. It takes quite a bit of doing to explain it, so this is giving the matter a bit of a short-shrift (eg no mention of people who aren’t moved by consideration of rates of return), and I don’t expect it to gain any “converts”. I don’t want to go into the fine detail yet again, though. Anyone interested can use the search function to find what I have written (and the really patient can wait until my book gets published, a few decades from now).

AROR = actual rate of return, the physical consequence of actually having employed real capital. RROR = required rate of return, what people would like to earn per unit of real capital. If AROR > RROR, people will net invest more capital; more capital makes AROR go down for standard diminishing returns reasons. If AROR=RROR, capital will be maintained steady. If AROR<RROR, people will net disinvest capital; reduced capital makes AROR go up (same returns reasons in reverse). The trend is for capital to go up or down until AROR matches RROR - this is standard market clearing, as applied to capital markets. The long-term determinant of the trend is the RROR because it is a target people have in mind when considering current and future capital investments. Total maintainable real capital is (loosely) inversely proportional to RROR.

In both cases of the bank investing in stock, this action pushes down AROR’s in an identical manner in the first instance. The contrast between the bank funding its stock investment via fractional versus non-fractional sources lies in the effect on the money supply, pricing signal distortions, the bank’s general riskiness, and what effects all these have on those influenced by the bank’s actions. The avoidance of FRB means the avoidance of generating those risks. Since nobody disputes that the practice increases risk, the question then becomes: is there or is there not a reward that compensates for those increased risks? Answer: no. Although the initial effect of the stock investment is identical, what happens afterwards is not.

In the fractional source case, core RRORs are untouched and the risks go up, so overall RROR’s go up. The initial spending by the bank only temporarily increases real capital, but, because this also pushes AROR’s down, that makes an incentive for others elsewhere to disinvest when they notice that AROR’s < their RROR’s. The net disinvestment continues until AROR’s rise back up again to meet the new, higher, RROR’s. If the RROR’s hadn’t moved, market ARORs and real capital bounce up then down again for a while before they damp down to settle back where they started from, but when the increased RROR plays into it (which will develop slowly over time as people start reassessing risks) the settle point for AROR’s is the now-higher RROR and the settle point for real capital lower than its starting point. The practice of FRB contributes nothing except risk, and so can only be deleterious. It is a negative sum game because the increase in real capital held directly by the bank is less than the decrease in real capital held in total by everyone else. The difference is turned to consumption.

In the non-fractional case, the avoidance of the aforementioned risks means RROR’s don’t go up. On top of that, because the bank is using proper investment sources (a demand deposit is not the provision of capital, whereas the purchase of a CD or bond etc is), the new availability of those sources means that the bank has come into possession of capital because its client would permit a reduction in market RROR’s: the investor’s action is making core market RROR’s go down - this is what doesn’t happen in the fractional case. As before the market ARORs and real capital will again bounce up and down for a while, but because the RROR is lower this means the settle point for the AROR is also lower than before and so the settle point for real capital is higher than before. The use of a non-fractional source of funding is thus a genuine investment, and so is beneficial. Investment from non-fractional funding sources is thus generally positive sum (there are other bank-practice considerations, however).

For so long as people don’t understand all this difference (even a well-educated professional investor like Galileo Blogs has difficulty), they are necessarily underpricing risk in terms of their evaluation of a fractional bank’s equity and financial products, in turn also underpricing the risk of other creditors and debtors dependent on the continued solvency of that bank, and from there the continued underpricing of general market risk as the bank’s influence radiates further and further out into the whole economy (predominantly via the money supply, but not exclusively so). The difficulty in understanding it arises because all this is related to real capital and real returns, independent of people’s estimation of the value of a unit of money. The observations of what happens in money terms is vastly different to what happens in real terms. That’s the distortion mechanism at work, arising from the practice messing with people’s means of converting nominal figures to real figures, and is one of the harder things to explain. In the LFC world, it is only that underpricing arising from that lack of understanding that would allow fractional banks to continue making profits and able to pay depositors interest. Y feldblum is right that government guarantees etc are pushing fractions WAY down from what they would be without those guarantees, but without the principled economic rejection of the practice the banking sector in an LFC world will have high fractions but still not 100% until that rejection and the proper reason for that rejection become widely understood.

JJM

62

The contrast between the bank funding its stock investment via fractional versus non-fractional sources lies in the effect on the money supply, pricing signal distortions, the bank’s general riskiness, and what effects all these have on those influenced by the bank’s actions. The avoidance of FRB means the avoidance of generating those risks. Since nobody disputes that the practice increases risk…

I have to chew on the FRB money supply effect and the other contrasts you mention. With that said, it seems to me that the depositer potentially gains from having his money in a fractional reserve bank. His alternatives (e.g. put it under a mattress, personally invest it, put it in a CD) are all worse in ways that might make FRB advantageous.

Do those contrasts (money supply effect, pricing signal distortions, bank risk) always outweigh any advantages to a FRB depositer?

Your post was detailed enough for me, thanks!

63

it seems to me that the depositer potentially gains from having his money in a fractional reserve bank. His alternatives (e.g. put it under a mattress, personally invest it, put it in a CD) are all worse in ways that might make FRB advantageous.

As stated that’s exactly right, and the depositor is perfectly justified in taking precisely that attitude without being informed of other considerations. It is the responsibility of us who are opposed to FRB to show those considerations.

Do those contrasts (money supply effect, pricing signal distortions, bank risk) always outweigh any advantages to a FRB depositer?

That depends on the state of knowledge of third parties. If the third parties don’t take sufficient action then the answer is no for the reasons already noted above. If the only relevant matters were the depositor’s judgement of pure investment risk (bank solvency) versus reward for taking that risk (interest, no account fees, etc), then there’s nothing in principle that says the depositor is wrong to choose in favour of a fractional account.

The problem is not exclusively the nature of the relationship between the bank and the depositor, but how the practice affects third parties and in turn how they respond to this. Third parties are having their risks increased without compensation and for no good economic reason because of the practice, and so they will increasingly take umbrage at the practice as they figure this out. It is a third party who will then start to say, for example, that they will automatically reject a cheque drawn on an account known to be fractional. So, even if the depositor in this instance thinks he’s on a winner because his cheque account pays interest that is more valuable than his estimate of risk of the bank dishonouring his accounts, he may find himself increasingly unable to use that account as the realisation of the general worthlessness of FRB spreads. His monetary benefit from the account starts to be outweighed by the administrative headache, and it snowballs from there until eventually the market for fractional accounts evaporates entirely. BUT, that presumes people knowing of the economic arguments against the practice, what damage it is doing, and hence properly pricing risk when they judge the value of all manner of financial products and investments. Again, it is the responsibility of FRB-opponents to make the case. Until that case is made and third parties do take action, the depositor is justified in taking what interest he can get as his judgement tells him is worth the risk.

JJM

64

The fraud argument seems baseless on the face of it, unless the bank actually actively deceives its depositers and lies about its fractional reserve system in some sense (claiming it has more reserves than it actually has, or claiming its a full reserve bank while not actually doing that.)

How is it fraud if everyone is aware of it to begin with? Am I missing something in the argument for it being fraud?

65

Are there any full reserve banks that operate in the U.S.?

66

Are there any full reserve banks that operate in the U.S.?

There are now! :

:dough:

67

The first ~1/2 of this article plausibly describes the functioning of fractional and full reserve banks, including the economics of the 2 systems. Might play to some of the issues that have arisen here.

68

The first ~1/2 of this article plausibly describes the functioning of fractional and full reserve banks, including the economics of the 2 systems. Might play to some of the issues that have arisen here.

Unfortunately, while Karl Denninger’s does make a few good points (there were many people who were gaming the system with other people’s money, and they should be sent to jail), the rest of his commentaries don’t stand up.

Again, the debate over fractional-reserve banking assumes the context of a commodity money such as gold, so at this point the debate is mostly hypothetical. The real problem is fiat (fraudulent) money, and it has been my argument that all forms of fraudulent money are harmful, fractional-reserve commodity money included, and non-commodity included as well. All forms of fraudulent money are possible only by legislative or judicial fiat, not by the market nor by the judgment of self-interested individuals. The fact is, it is not even possible to deposit specie in the bank in exchange for a money-title note: it is not possible to put an ounce of gold in the bank and get back a banknote giving full right and title to that ounce of gold to whoever is the bearer of the note, and giving full right to redeem that ounce of gold on demand. Talking about fractional-reserve banking in the context of a non-commodity money simply makes no logical sense. (My prior discussions on the topic assume a commodity money.)

Supposing we were on a commodity money, then the debate over fractional-reserve banking would become relevant. And here’s the issue: two people lay claim to the same physical ounce of gold sitting in the bank’s vault, and use their two separate claims to the same physical ounce of gold in their day-to-day dealings. Someone is getting screwed, because when that single physical ounce of gold is withdrawn and there isn’t another ounce of gold to replace it, one of the claimants is going to be out one ounce of gold. Multiply this by an entire economy, and you’ve got yourself a cycle of booms and busts, and a government capitalizing on fear to grow itself exponentially.

69

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

Sorry for coming into this thread late, but it’s one of my favourite topics, so I thought I’d chime in.

Steve: your statement is incorrect. If you have a $20 note in your pocket, you can lend it to someone (if you are doing it in a way akin to banking, you will accept from him an IOU, which you will destroy or return to him when he returns $20 to you). He can then lend it to someone, who can lend it to someone else, Etc, Etc. The successive loans do not increase the money supply. You are lending without resorting to fractional reserves. A bank can do the exact same thing that you can do.

Here’s another example. If it is the case that your promises to pay federal reserve notes (i.e., your IOUs) are reliably accepted by everyone in exchange for goods and services, then your IOUs are “money”, in the current definition of that term (but not “money” as defined by Ayn Rand: Rand defined money such that only “existing goods” - as opposed to promises/credit/fiduciary media - could qualify as “money”). If you a $20 federal reserve note in your pocket, you can lend someone a “Steve D’Ippolito IOU” in the amount of $20. If you thereafter ensure that you do not spend/use/transfer-to-others the $20, you are lending on a 100% reserve. Again: a bank can do the same thing that you can do.

Here’s a third example. I lend you $20 worth of federal reserve notes. You agree to pay 3% interest on it and don’t have to have to repay the money for 6 months. I agree that, during that 6 months, I will have no right to withdraw from you my $20. You thereafter lend someone a “Steve D’Ippolito IOU” in the amount of $20: the loan must be repaid in full, along with 5% interest, by the end of the aforementioned 6 months. If you ensure that you keep in your vault the $20 I loaned to you, you are lending on a 100% reserve.

In short: 100% reserve banking does not preclude lending. It merely requires that the bank have currency reserves equal to the IOUs it has issued. That ensures that a bank can, at all times, simultaneously honour all of the IOUs it has issued.

Are there any full reserve banks that operate in the U.S.?

Sure: the Bank of Mom and Dad.

70

The fraud argument seems baseless on the face of it, unless the bank actually actively deceives its depositers and lies about its fractional reserve system in some sense (claiming it has more reserves than it actually has, or claiming its a full reserve bank while not actually doing that.)

How is it fraud if everyone is aware of it to begin with? Am I missing something in the argument for it being fraud?

It’s not fraud IF everyone is aware of it, clearly. However:

(a) fraud is not the essential problem; and

( B) even if it were, it is patently false that everyone understands banks to be issuing more credit than they can simulaneously honour with currency.

The essential problem is: increasing the number of dollars that comprise the money supply - whether increasing it by means of issuing more federal reserve notes, or by issuing more private bank credit, because both are “money” in the issue-relevant sense of the term (which is not the sense in which Ayn Rand meant “money”) - devalues all pre-existing dollars and transfers that value to the newly-created dollars. Increasing the number of dollars - “inflation” as it is properly defined (as cause, rather than as effect) - results in a non-consensual redistribution of wealth from (a) those who earn it, to ( B) those who simply create additional dollars. That’s why counterfeiting is a crime: by inflating the money supply, the counterfeiter devalues everyone else’s dollars, enriching himself at their expense.

In short: the essential issue is not fraud, but theft.

71

Bank-issued credit, while part of the money supply, differs from currency in two important respects:

First, bank credit expands as the market price of underlying assets expands (and vice versa), unlike fiat currency, which expands based on the whim of the savage-in-chief, so the value of bank credit in real (e.g., gold) terms remains steady during the boom.

Second, when the price of the underlying assets collapses, the value of the credit collapses, but not necessarily the value of currency, which often increases in value during a bust (if bank credit has replaced, not just augmented, currency).

The result is that bank credit expands the money supply during a boom, but contracts it during a bust, maintaining the value of the underlying commodity currency.

These, I think, are important distinctions, because they shift the issue to one of fraud, or, at least, voluntary ponzi or musical dollars, in the case of bank credit expansion.

In the case of currency expansion, it is clearly theft.