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100% reserves: confusion about “money”

by Kurt Schuler July 17th, 2012 12:01 am

The idea that fractional reserve banking is fraudulent comes partly, I think, from confusion about different senses of the word “money.” Money in the narrow sense is the monetary base, which, at least from the standpoint of the domestic monetary system, is a pure asset and not somebody's IOU. Payment with the monetary base extinguishes IOUs.

(Asides: From the standpoint of the international monetary system, the monetary base may not be a pure asset if it is convertible at a set rate into something else, whether a commodity or a foreign currency, but ultimately, in all the cases I can think of, the trail ultimately leads to a pure asset. A government-issued pure fiat money is not an IOU because, though the government typically accepts it in payment of taxes, there is  no fixed relationship between the fiat money unit and the tax paid or with any good.)

“Money” in the looser, broader sense includes IOUs, particularly those issued by banks, that are readily convertible at 1:1 into the monetary base.

A 100% reserve bank would be a kind of warehouse. Many banks offer warehousing services: they are called safe deposit boxes. I am aware of no bank for which safe deposit boxes are anything more than a side line of business, though. Because 100% reserves preclude lending funds out at interest, a 100% reserve bank would have to charge storage fees just as banks do for safe deposit boxes. Customers’ acceptance of interest paid by banks, or of “free” services offered by banks in lieu of interest, is an implicit recognition that customers are not warehousing assets, but allowing banks to act as their agents in lending out funds.

When we talk about “money in the bank,” we are talking not about the monetary base but about bank IOUs. It would be more accurate to use the phrase “credit in the bank,” because that’s what most of it is: IOUs by bank borrowers to which bank depositors are claimants.

The use of the word “money” to cover both things that are pure assets and those that are IOUs leads to confusion in other aspects of monetary economics also, especially when defining and discussing the money supply. That is a topic for another day.

ADDENDUM: Thank you for the comments, some of which raise issues I will address in the future (particularly Mike Sproul's point about the balance sheets of fiat money issuers). By a "pure asset" I mean something that is not a claim to something else. A lump of gold is a pure asset. So is perhaps the starkest example of fiat money: occupation currency, where an occupying army comes into a country, prints up notes, and forces people at gunpoint to accept the notes in payment for goods. Typically the notes are not freely accepted for payments to the home country of the occupying army. (I didn't say they were a good asset.) A "pure asset" is distinguished from an asset that is a claim to something else, such as a bond, which is a claim to a stream of future payments.

46 Responses to “100% reserves: confusion about “money””

  1. avatar StoneGlasgow says:

    What is a "pure asset?"

    • avatar Martin Brock says:

      I can't speak for Kurt, but a "pure asset" seems to be an unleveraged asset or an asset on which no one has a lien or an asset with a single owner.

      What is "pure fiat money"? In my way of thinking, a "fiat money" is money by fiat, by decree, by the force of the state. People use fiat money because a state forces it to circulate by drawing it out of an economy forcibly through taxation and similar impositions and simultaneously pumping it into the economy through spending and other distributions like writing Social Security checks and paying interest and principal on Treasury securities.

      In this sense, Bitcoin is not fiat money unless a state makes Bitcoin a legal tender for payment of taxes and other rents and sells entitlement to the tax revenue and the like. On the other hand, gold can be fiat money if a state makes it a legal tender and the rest.

      Bitcoin has no intrinsic value, no value as anything other than money, while gold has an intrinsic value because it has uses other than as money; however, this distinction does not make Bitcoin a "fiat" money. "Fiat money" does not describe a scarce thing used exclusively as money (in my way of thinking).

      On the other hand, many people think of Bitcoin as a "private fiat money". These people understand "fiat money" differently, and this divergent usage is the source of much confusion among liberals.

    • avatar David Stinson says:

      Rather than "pure asset", I prefer "store of value without counterparty risk".

      • avatar Martin Brock says:

        "Store of value" sounds like "good with unchanging, real value". Is that what you mean? Does such a good exist?

        • avatar David Stinson says:

          " "Store of value" sounds like "good with unchanging, real value". Is that what you mean? Does such a good exist?"

          While obviously a nice feature, I don't think constant real value is a prerequisite for something being used as a store of value (see: US$ or t-bills). "Roughly stable real value or small predictable loss in real value" over whatever one's expected holding period happens to be is probably enough. When people rush to hold the US$ or t-bills periodically during the euro crisis, it's not because they think those assets have constant real value forever and it's not a vote of confidence in the long run soundness either of the US$ or the fiscal position of the US. They have very short holding periods (even if constantly renewed due to continuing crisis). In fact, it is often the case during such episodes that, relative to other assets, the dollar and t-bills go up in value.

  2. avatar Mike Sproul says:

    "A government-issued pure fiat money is not an IOU because, though the government
    typically accepts it in payment of taxes, there is no fixed relationship
    between the fiat money unit and the tax paid or with any good."

    Some problems:

    1) Does the US dollar meet your definition of fiat money? If so, why does the Fed hold assets against it? Why are paper dollars recorded as a liability of the Fed? Back when the dollar was convertible into gold, would you have said it was a fiat money? When convertibility stopped, did the dollar suddenly become fiat money on that very day? If not, how much time has to elapse after suspension before you declare it a fiat money? Do you think "inconvertible"="unbacked"?

    2) A bank issues a dollar that promises to pay out 1 oz of gold on demand. A government issues a dollar that promises to extinguish a 1 oz. tax liability on presentation. Both are backed and convertible. What if the rate of convertibility becomes a little shaky, and is no longer truly fixed. Would you then call both kinds of dollars fiat money. Just how 'unfixed' does the dollar have to become before you call it fiat money?

    • avatar Martin Brock says:

      1) The U.S. dollar is fiat money, but it's not fiat money because it's unbacked. It's fiat money because it's backed by entitlements to tax revenue (like Treasury securities) and forced to circulate through taxation and similar rent collection and state spending.

      2) Needless to say, I don't want the government issued dollar at all, because I don't much want the tax liability at all. The coercion is the problem, not the unbackedness or inconvertibility.

      If the convertibility becomes shaky, if the statutory monetary authority tolerates or engineers a little inflation, I don't much care. It's secondary issue to me. The inflation may have ill effects, but these effects are not the ill I oppose primarily. I can imagine less coercive money inflating, and I have no fundamental problem with that.

      • avatar Mike Sproul says:

        Martin:

        1) Econ textbooks are almost, but not quite, unanimous in defining fiat money as being money without backing, and they explain fiat money's value as resulting from the fact that it is (1) in demand (mostly for liquidity, but texts sometimes (rarely) also mention taxes as a cause of money demand.) (2) Limited in supply. I disagree with this view, and I suspect you do too. I say that modern paper money, which is universally called fiat money, is actually backed money. Sometimes it is backed by central bank assets, and sometimes by the government's assets (i.e., 'taxes receivable'), but backing is backing, and the value of backed money is always determined by the value of the assets backing it.

        So, for debating purposes, I suggest we define fiat money as being money that lacks ANY backing, and then if you want, we can also talk about tax-backed money, bank-asset-backed money, etc. There's also a problem of what 'convertible' means. Convertible into gold? into bonds? into things denominated in the money itself? into tax payments?

        2) This is not clear. Government's issuance of paper money does not (directly) cause me to have to pay more taxes. Also, the government's declaration that it will accept bits of paper is not, by itself, coercive. The taxes themselves might be, but not the acceptance of paper.

        • avatar David Stinson says:

          The Economist Dictionary of Economics defines fiat money as "(c)urrency that is legally decreed a valid means of financing transactions." This is consistent with what I was taught.

          Wikipedia says that "(t)he term fiat money has been defined variously as: any money declared by a government to be legal tender; state-issued money which is neither convertible by law to any other thing, nor fixed in value in terms of any objective standard; [and] money without intrinsic value."

          In Latin, fiat means "let it be done." In English, it usually means an authoritative or arbitrary order or decree.

          I would have thought that fiat money could by those definitions either be backed (e.g., created in the act of buying something) or unbacked but just not convertible.

          • avatar Martin Brock says:

            I use "fiat" more this way, but Mike gave me an A, so I'll follow his lead for a while. Of course, one A only gets you so far.

          • avatar Mike Sproul says:

            David:

            Consider the following kinds of paper money:
            1. Issued by a private bank, backed and convertible into gold at $1=1 oz.
            2. Issued by a private bank, backed by gold and bonds but not convertible into gold, but the private bank uses its bonds to buy back its money if its value falls below $1=1 oz.
            3. Same as (1) but issued by a government bank
            4. Same as (2) but issued by a government bank
            5. Issued by a landlord who accepts it in exchange for rent at $1=1 oz.
            6. Issued by a landlord who does not tie it to gold, but uses his bonds to buy back his dollars if they fall below $1=1 oz.

            In a sense these are all fiat money, because they were all created by someone's decree. In another sense none are fiat money, because they are all backed by the assets of their issuers. That's why I don't like the word 'fiat money'. If 'fiat' means 'unbacked', then I would say there's no such thing as unbacked money. Money with no backing will have no value. If we're going to talk about backed money, then we can talk sensibly about whether it is convertible into gold, into bonds, whether convertibility is instant, delayed, certain, uncertain, etc., but there's no reason for the word 'fiat'.

          • avatar Martin Brock says:

            Mike:

            For me, who owns the bank is not the issue. I can imagine a scenario in which a state nationalizes banking and all bankers become state employees, but still there is no legal tender, there is no central bank with an exclusive right to issue circulating notes, there is no sovereign debt backing notes, capital other than sovereign debt backs notes, and there is little taxation and state spending. In this scenario, I would not call notes issued by these state banks "fiat money", because a legal tender law and the force of a state taxing and spending does not keep the money circulating (and maybe the money doesn't circulate much).

            Nationalizing banks this way might wreck an economy (and the bank's balance sheets) by politicizing credit, but that's a separate issue. There are lots of ways to wreck an economy. In this scenario, people could resort to barter or other sorts of money, or they could reinvent "banking" under another name somehow.

            In a futile and increasingly comical effort to feel like I'm not middle aged (and beyond), I converse a lot with young anarcho-capitalists. They tend to hate "fiat money" but love Bitcoin. By your definition, Bitcoin is the purest sort of fiat money, so hating fiat money and loving Bitcoin indicates a contradiction in terms. Your usage could be swimming against a rising tide.

            Also, I see proprosals for returning the U.S. to a gold standard, by force, from people nominally opposing "fiat money". Basically, these proposals convert existing obligations to pay dollars that do not promise gold into obligations to pay dollars that do promise gold at a fixed rate, without eliminating legal tender laws or defaulting on Treasury securities or anything similar. I don't like this idea at all, and I don't think it solves most problems that I associate with "fiat money" at all. Do you agree?

            Keynesian "business cycle dampening" through state spending has no problem with a gold standard. Right?

          • avatar Mike Sproul says:

            Martin:
            I'm the wrong person to ask about what Keynesians think. I had to choke down too much of that claptrap in graduate school, and these days I have the luxury of not having to think about it. It was a happy day when I realized that I couldn't remember which way the IS and LM curves sloped.

            I don't consider government-issued money to be fiat money because those moneys are all backed by taxes receivable. On my definition, a true fiat money is unbacked by anything. I contend that there is no such thing as unbacked money. This leaves me having to explain things like bitcoin, wampum, stones on the island of Yap, the Iraqi Swiss Dinar, Somali currency, and monopoly money that circulated on some pacific islands after WWII. It's a weak point that quantity theorists are quick to attack (e.g., Scott Sumner, "The quantity theory vs. the backing theory, Round 1"). My answer is that those things have value either because of ignorance (monopoly money) or else they have value for the same reason that baseball cards have value. I haven't convinced too many people with that, but unbacked money just leads to too many absurdities, so I'm sticking to the view that there is no such thing.

    • avatar Martin Brock says:

      I read your paper on the real bills doctrine yesterday, and I agree that I advocate the doctrine here. I still advocate it, so the counterarguments you discuss have not persuaded me, but I'll play devil's advocate a bit.

      Does Thornton deny that creditors will demand sufficient collateral or does he deny that creditors can demand this collateral? In other words, does he only claim that a creditor cannot be sufficiently certain that his collateral has no existing lien for which he does not account?

      If Thornton's argument involves necessary uncertainty, maybe he has a point. Your counterargument seems to be that every pound of debt has sufficient security by assumption, and the doctrine (as you define it) does make this assumption, but can the assumption be true as a practical matter?

      I would say that even if the assumption were debatable in Thornton's time, it is much less debatable now. A timely title search is precisely the sort of problem that modern information technology can address.

      Also, if necessary uncertainty causes creditors to issue inflationary notes, this uncertainty seems to imply that extending credit ultimately cannot be a profitable business model at all. Do you agree?

      What do you think of the idea that creditors ultimately end up extending credit into fat tailed risk distributions, because the business itself shapes the distribution this way? Basically, the capital market is like a random walk generating a lognormal distribution of yields, and the tail of this distribution is increasingly fat.

      If banks occasionally fail, even if every bank inevitably fails eventually, who cares?

      I frowned when you wrote that Bank of England notes were backed by sovereign securities, but I later smiled when you claimed that depreciation of the pound reflected depreciation of these securities.

      I emphasized "productive loans" myself here recently, but you say this emphasis is mistaken. Doesn't a productive loan signal that collateral remains of sufficient value?

      (Ricardo, 1811, p. 117) confuses me. Ricardo seems to assume that secured, bank issued money remains permanently in circulation or that it returns to the issuing bank only to pay bills, that people don't deposit money in a bank only to save and collect interest (essentially to invest in the bank's collateral), that people do not use banks to outsource their rent-to-own arrangements as I have supposed. Do you agree?

      I understand your point about bank assets backing bank money, but I still have a possibly mistaken sense that the "quantity theory" is correct, that inflation (generally rising prices) is a product of too much money in circulation. My sense is rather that bank notes backed by collateral do not circulate permanently.

      In a mortgage scenario, the owner of a house wants liquidity, though possibly not the entire value of his house. A bank issuing circulating (or circulatable) notes enables this owner to liquidate all or part of the value of his house. This liquidation increases the money supply temporarily, but after a few transactions, someone else effectively holds part of the equity of the house, and at this point, the money supply decreases again. An effective co-owner of the house has "money in the bank", but it's a mistake to think of this "money" as part of the circulating money supply. Do you agree?

      The Mints argument does seem to describe what happens now, with our bailout driven system. Central bankers effectively engineer a little inflation into the system precisely to provide a continual bailout for creditors. Do you argue that a stable, free banking system avoids the necessity of this systematic bail out by demanding less highly leveraged collateral, higher downpayments and no second mortgages for example?

      • avatar Mike Sproul says:

        Martin:

        I've tried to insert my answers into your text below.

        MB: Does Thornton deny that creditors will demand sufficient collateral or does he deny that creditors can demand this collateral? In other words, does he only claim that a creditor cannot be sufficiently certain that his collateral has no existing lien for which he does not account?

        MS: Thornton was not even thinking of this. He mistakenly thought that the real bills rule would cause the money supply to move in step with the quantity of goods produced. He then mistakenly claimed that since the same quantity of wheat could change hands s times in a month, the quantity of money could outstrip quantity of goods by a factor of 6. The correct view of the real bills doctrine is that following the real bills rule causes the money supply to move in step with the ISSUER's ASSETS.

        MB: If Thornton's argument involves necessary uncertainty, maybe he has a point. Your counterargument seems to be that every pound of debt has sufficient security by assumption, and the doctrine (as you define it) does make this assumption, but can the assumption be true as a practical matter?

        MS: That's the lenders' problem. If they lend against assets already liened by another lender, they lose.

        MB: I would say that even if the assumption were debatable in Thornton's time, it is much less debatable now. A timely title search is precisely the sort of problem that modern information technology can address.

        Also, if necessary uncertainty causes creditors to issue inflationary notes, this uncertainty seems to imply that extending credit ultimately cannot be a profitable business model at all. Do you agree?

        MS: Again, that's the lender's problem. Smart lenders will earn profits. Dumb lenders will lose.

        What do you think of the idea that creditors ultimately end up extending credit into fat tailed risk distributions, because the business itself shapes the distribution this way? Basically, the capital market is like a random walk generating a lognormal distribution of yields, and the tail of this distribution is increasingly fat.

        MS: I never thought about it.

        MB: If banks occasionally fail, even if every bank inevitably fails eventually, who cares?

        MS: Their customers care, but nobody else should.

        MB: I frowned when you wrote that Bank of England notes were backed by sovereign securities, but I later smiled when you claimed that depreciation of the pound reflected depreciation of these securities.

        I emphasized "productive loans" myself here recently, but you say this emphasis is mistaken. Doesn't a productive loan signal that collateral remains of sufficient value?

        MS: A loan to a farmer or carpenter is 'productive'. A loan to a gambler or a tourist is unproductive. The bank who gets adequate collateral has no reason to care if a loan is productive or not. The borrower can invest in moon colonies, for all the bank cares.

        MB: (Ricardo, 1811, p. 117) confuses me. Ricardo seems to assume that secured, bank issued money remains permanently in circulation or that it returns to the issuing bank only to pay bills, that people don't deposit money in a bank only to save and collect interest (essentially to invest in the bank's collateral), that people do not use banks to outsource their rent-to-own arrangements as I have supposed. Do you agree?

        MS: Ricardo didn't understand the law of reflux. I'm not sure what you're asking here.

        MB: I understand your point about bank assets backing bank money, but I still have a possibly mistaken sense that the "quantity theory" is correct, that inflation (generally rising prices) is a product of too much money in circulation. My sense is rather that bank notes backed by collateral do not circulate permanently.

        MS: This is all explained by the law of reflux.

        MB: In a mortgage scenario, the owner of a house wants liquidity, though possibly not the entire value of his house. A bank issuing circulating (or circulatable) notes enables this owner to liquidate all or part of the value of his house. This liquidation increases the money supply temporarily, but after a few transactions, someone else effectively holds part of the equity of the house, and at this point, the money supply decreases again. An effective co-owner of the house has "money in the bank", but it's a mistake to think of this "money" as part of the circulating money supply. Do you agree?

        MS: I hate to sound like a broken record, but the law of reflux explains this. If the money is wanted it will circulate; if not it will reflux to its issuer. Trying to define what is part of the money supply and what is not is a hopeless exercise.

        MB: The Mints argument does seem to describe what happens now, with our bailout driven system. Central bankers effectively engineer a little inflation into the system precisely to provide a continual bailout for creditors. Do you argue that a stable, free banking system avoids the necessity of this systematic bail out by demanding less highly leveraged collateral, higher downpayments and no second mortgages for example?

        MS: Yes; smart bankers only lend against adequate collateral, so they rarely go broke.

        • avatar Martin Brock says:

          Forgive the long reply. You've sparked my interest.

          He then mistakenly claimed that since the same quantity of wheat could change hands 6 times in a month, the quantity of money could outstrip quantity of goods by a factor of 6.

          I understand you, but I'll work through an example for my own sake and for anyone else interested.

          George sells me a hundred dollars worth of wheat on credit for six months, i.e. he allows me to pay for the wheat over six months.

          George spends my obligation to him on Paul's corn, i.e. Paul accepts my obligation in exchange for his corn, expecting me to pay him for the corn over six months instead of paying George for the wheat.

          I resell the wheat on credit to you. I let you pay me for the wheat over six months.

          You owe me a hundred dollars, and I also spend this obligation on Paul's corn. You then own Paul a hundred dollars.

          You and I owe Paul two hundred dollars.

          You sell the wheat again to David, and you then exchange David's obligation for Paul's corn.

          Three people owe Paul three hundred dollars.

          We repeatedly use bills for the same wheat as money, and all of this selling on credit generates a lot of demand for Paul's corn, but the demand does not devalue our money if George holds my collateral worth a hundred dollars and I also hold your collateral and you hold David's collateral.

          The wheat itself may be George's collateral or my collateral or your collateral, but it may not be George's collateral and my collateral and your collateral. [This was my point about liens.]

          While we follow this rule, our bill-money does not devalue, because collateral valuable before each transaction backs each unit of the money.

          That's the lenders' problem. If they lend against assets already liened by another lender, they lose.

          It's the lender's problem ultimately, but Thornton seems to suggest that lenders can't solve the problem as a practical matter, because of uncertainty over the collateral, and if they don't solve it properly, it causes inflation by generating all of this demand for Paul's corn without any goods of comparable value. I'm not agreeing with him, but that seems to be his assumption. The same assumption seems to imply that extending credit as a business model is a lost cause.

          Again, that's the lender's problem. Smart lenders will earn profits. Dumb lenders will lose.

          Maybe lucky lenders earn profits and unlucky lenders lose, but I don't suppose it matters as long as winning is frequent enough.

          I emphasize "luck" over "smarts" here not to diminish the importance of smarts but to raise the efficient market hypothesis. Information matters, but prices quickly reflect relevant information in an efficent market. When seeking to employ our smarts, we're always on an information frontier where only the scarcest, least recently employed information is very valuable, and on this frontier, luck must play a substantial role, because trial and error is how we obtain the scarcest information in the first instance.

          I associate economic development in a free market with a process like evolution by the natural selection of random mutations. The invisible hand is not mindless, but the mind of the market is much smarter than any individual can possibly be. Do you agree?

          I never thought about it.

          I haven't thought about it much recently, but I considered doing a master's thesis (in applied mathematics) on the idea once.

          A loan to a farmer or carpenter is 'productive'. A loan to a gambler or a tourist is unproductive. The bank who gets adequate collateral has no reason to care if a loan is productive or not. The borrower can invest in moon colonies, for all the bank cares.

          I understand, but if the borrower's labor itself is not the collateral, then the collateral itself can have a marginal productivity independent of the farmer or gambler. The banker doesn't actually possess the collateral. He only holds its title. The productivity of the loan (principal and interest payments keep appearing) could be evidence that the marginal productivity of the collateral persists.

          Ricardo didn't understand the law of reflux. I'm not sure what you're asking here.

          I'm only asking you to confirm my suspicion that my "rent-to-own" understanding of the banking process is equivalent to the law of reflux. I agree that "money supply" is a poorly defined notion, but I'll stick with it for the sake of discussion. The notion is nonetheless common, and others may read our exchange.

          We don't ordinarily say that a house is part of the money supply. If the house has two or three or four co-owners, it still isn't part of the money supply. If an owner rents a house, it doesn't become part of the money supply. If an owner accepts a rent-to-own contract, this contract gradually transfers title to the house to the renter/buyer, but the contract doesn't immediately and permanently increase the money supply by the value of the house.

          A bank holding collateral effectively owns the collateral and collects rent on it. More precisely, the bank issues shares of the collateral, and shareholders collect the rent. These "shareholders" are the bank's depositors, not bank shareholders in the usual sense. [Selgin disputes this way of thinking, but he hasn't persuaded me of its fallacy.]

          These shares of collateral are money only if the shareholders use them as money, only if people accept shares in trade only to trade them again soon thereafter.

          So what's the difference between holding an entire house worth $100,000 and holding a single share of a house worth a dollar? We never call the former "money". When should we call the latter "money"? In terms of the quantity theory, when is the latter part of the "money supply"? [I know you dispute the quantity theory, and I understand your reasoning.]

          An individual holding shares of bank collateral ("money in the bank") increases the money supply temporarily by using shares as money, but this individual may also choose not to increase the money supply by instead using the shares to collect rent on the collateral.

          A one dollar share of a house is only part of the money supply while people use it as money. When people aren't using the share as money, it is property held, and property held is not money by definition.

          When I spend a dollar from my bank account, I increase the money supply momentarily. I create money by liquidating my property. The bank doesn't create this money. I and the person accepting the dollar from me in trade create the money. This other person may then decrease the money supply by depositing the dollar back in the bank, whereupon the dollar becomes property held again and thus ceases to be money.

          This transformation of circulating money into property held is "reflux". The law of reflux states that the money supply (in the free banking scenario) is only as large as necessary to accomodate the demands of proprietors for indirect exchange, because when people need less money, money returns to the issuer by this reflux and ceases to circulate.

          Similarly, I may use a silver coin as money, or I may melt the coin and make a ring from the silver. The silver is money only while people use it as money.

          Finally returning to Ricardo, Ricardo writes, "... an addition might then be made to a circulation already sufficient, without occasioning the notes to return to the bank in payment of bills due."
          But when a bank accepts a seller's house as collateral and issues banknotes accordingly, the notes don't circulate until the buyer (or someone else) returns them to the bank in payment of bills due. The notes return to the bank immediately when the seller deposits them in the bank. They cease to be money immediately, as though the seller had accepted a rent-to-own contract with the buyer directly. The seller may create money from his bank deposit at will, but we can't say that any of the value of the house circulates as money indefinitely, and any value that does circulate as money may reflux back to property held in a "rent-to-own" arrangement at any time.

          Trying to define what is part of the money supply and what is not is a hopeless exercise.

          I see your point here. The quantity theory makes less sense to me all the time.

          Yes; smart bankers only lend against adequate collateral, so they rarely go broke.

          The value of collateral is uncertain and also variable over time. Is "smart" here equivalent to "risk averse"?

          • avatar Mike Sproul says:

            Martin:

            You're about 99% correct (which puts you in the A+ range, by the way), so if I don't answer some of your points you can be 99% sure that I agree with them. A few points that I would add:

            1. George, Paul, and David: Yes, it's the liened property that gives the newly-created money value. The $100 worth of wheat might have backed $100 worth of money, but no more. Real bills critics often mis-characterize the real bills doctrine as a belief that following the real bills rule will make the money supply move in step with the economy's overall output of goods, when in fact it makes the money supply move in step with the assets of the money-issuers.
            2. 'Lucky' and 'smart' are sort of interchangeable. I'm careless about my use of the terms, just because it's more of a microeconomic/finance problem than a monetary theory problem.
            3. You clearly understand the hopelessness of defining 'the money supply', but I think you need to pound it into your head a little harder. Measuring the money supply only matters to people who think in terms of MV=PQ, and thus believe that a rise in M can increase P. Of course, if you have personally issued some money that has your name on it, then you would care very much how many money units you have issued, and how much backing you have behind them. But you don't have much reason to care how many currency units other folks have issued. Their money is their problem.
            4. "A bank holding collateral effectively owns the collateral and collects rent on it."
            You must mean something else by this. The bank has a lien on my house, but I'm the one who collects rent.

          • avatar Martin Brock says:

            You must mean something else by this. The bank has a lien on my house, but I'm the one who collects rent.

            I'm trying to say that banks don't really collect "interest on money" from borrowers. They really collect rent on collateral and call it "interest on money". The collateral is the real, useful asset. Because its use has value, I'll pay to rent it. A bank "lends money" to me, accepting collateral securing the loan, and receives "interest" on the money. We might as well say that the bank monetizes the collateral (issues fixed value shares of the collateral that circulate as money) and then rents the collateral back to me. It rents the collateral on behalf of people holding the shares, and it keeps a portion of the rent as a fee for its money issuing service.

          • avatar Mike Sproul says:

            Martin: OK I see what you mean now.

  3. avatar Paul Marks says:

    There is no confusion here - at least not from the critics of credit bubble finance. From Richard Cantillon in the 1700s, to the "Currency School" foes of the "Banking School" in the 19th century, to Ludwig Von Mises and others in the 20th century (although it should be noted that whilst Mises and Hayek, at least Hayek before he reached old age, supported the Currency School against the Banking School they were always careful to add that they supported the Currency School description of the problem NOT the Currency School "solution" to the problem).

    The critics do NOT claim that banks have a secret printing press (or coin manufacturing operation - much like the light weight fake "Polish" coins that Frederick the Great produced to cheat people) in the basement.

    What is claimed is that banks EXPAND CREDIT (call it "M3" or whatever you like) - i.e. that they lend out "money" that no one really saved.

    This credit bubble (credit expansion - "broad money") creates a "boom" of malinvestments and general economic activity, which ends (MUST end) in a BUST where the malivestments are liquidated and the "broad money" (the credit bubble) shrinks back down towards the monetary base).

    By the way.....

    This shows that bankers ON THEIR OWN can not create a long term grand inflation (i.e. a long grand increase in the money supply - the misguided Irving Fisher defintion of inflation as an increase in the "price level" is an error and a terrible one, it led him to be surprised by both the BUST of 192

  4. avatar Paul Marks says:

    Hit the wrong key - I will finish the comment here.

    Fisher's error of defining "inflation" as an incease in the "price level" led him to be surprised by both the BUST of 1921 and that of 1929 - indeed not even to understand the BUST of 1929 after it had occured.

    Lack of understanding that credit money "boom" (an increase in "broad money" - i.e. bank credit, "money" that was never really saved) must lead to a BUST is what misled Irving Fisher - and those who followed in his tradition (to this day).

    But I REPEAT bankers ON THEIR OWN can not create a grand long term inflation (i.e. increase in the money supply) - this is because the credit money "boom" (the credit bubble) is liquidated by the BUST.

    This is NOT a neutral process (as Richard Cantillon noted as far back as the 1700s the economy would have been better off had the boom-bust not occured, and the people hit are especially the poor and those without political connections), but nor is it a long term inflationary process (as the BUST liquidates the "broad money" i.e. the credit bubble).

    Only if the government (and/or Central Bank) steps in to "save the financial system" (from the BUST) "save the economy" by expanding the MONETARY BASE can long term grend inflation (i.e. a vast increase in the money supply over time) occur.

    What banks do is NOT lend out a "fraction" of real savings (as the word "fraction" is used in everyday speech) they lend out FAR MORE than real savings.

    What is called "fractional reserve banking" is NOT lending out (for example) nine tenths of real savings - it is lending out 11 tenths, or 30 tenths, or 100 tenths (a "fraction" in pure mathematics - but not in the way the word "fraction" is used in everyday speech). This is achieved by CREDIT EXPANSION (by credit BUBBLE building). However, this is NOT inflationary in the long term - as the credit expansion (the credit BUBBLE) is liquidated by the BUST - and the bigger the credit expansion (the bigger the BUBBLE) the bigger the BUST.

    It is GOVERNMENTS (and Central Banks) who create long term grand inflation - by their efforts to "save the financial system", "save the economy" i.e. SAVE THE CREDIT BUBBLE - by expanding the monetary base.

    I must also say that I am greatful to Kurt Shuler for not repeating the defence of credit bubble finance that some people come out with - i.e. that bank lending is "100% covered" by a bank's "capital and reserves".

    When examined this claim (which I repeat Kurk Shuler has NOT made) that bank loans are "100% covered" by a bank's "capital and reserves" turns out to be about as rational as claiming that they are 100% covered by magic pixie dust.

  5. avatar Remarkl says:

    I would not be so kind to the idea of fractional reserve banking as "fraud." The pejorative connotation gives away the claimant's animus. The "idea" comes from the desire to paint a process the claimant does not like in an unpleasant way.

    "Fraud," in any useful sense, requires intentional deception. Yes, under the securities laws, one can commit "fraud" negligently, but that's just lawyerese. When a hard-money guy - and ONLY hard-money guys call FR "fraud" - uses the term, it is to connote, not to denote. People do not think "I used to like soft money, but FR is fraud, so now I don't." They think "I don't like soft money, so what can I call FR?" It's propaganda, not argument or analysis.

    I would be interested to see evidence that "the credit expansion (the credit BUBBLE) is liquidated by the BUST." Obviously, the bust destroys market value, and it may reduce the money supply, but where is the necessary equivalence? Are there no soft landings? Do we not see higher lows founded on value created in the boom process? An empty parcel is worth 1 in Bust 1, 3 after being developed in Boom 1, and 2 after Bust 2. The value added by the building will support collateralized lending FOREVER no matter what. Where is the government's hand in that?

    Credit money is "backed" by the value that the banker believes it will create, the entropy it will reverse. The fallacy of composition causes bubbles: bankers believe business plans that underestimate the competition for customers or resources that the borrower will encounter, and then a lot of loans fail to perform, because the value does not materialized to support them. Whether the bank has enough capital or reserves to weather the storm is each banker's look-out, but it has nothing to do with "backing" the loan. The loan is just the present value of the future cash flows that the banker believes the loan will support with a certainty that allows the loan to be made at the bank's tolerance for leverage.

    • avatar Remarkl says:

      Let add that I don't want to imply that central banks do not foster inflation - they target it so that idol money will become capital. But they may not need to CREATE it; they may need in fact to CONSTRAIN it from exceeding target. OR, they may seek to create it, by encouraging FR lending. Government spending alone SHOULD be non-inflationary. It should buy value, and it should be offset by taxes to the extent that it does not tap excess (non-inflationary) capacity.

  6. avatar michaelsuede says:

    "The idea that fractional reserve banking is fraudulent comes partly, I think, from confusion about different senses of the word “money.”"

    The idea that fraction reserve banking is fraud comes from the fact that people are allowed to withdraw from interest bearing accounts without a time-deposit restriction, yet they are told that their money is not at risk of potentially being lost in the event the bank goes bankrupt or a bank run occurs.

    As was already noted, fraud entails deception. There is no fraud as long as the bank makes it explicitly clear to its customers that they are putting the customer's savings at risk by not maintaining enough reserves to pay every account holder in full should a bank run occur. Of course, such disclosures are virtually unheard of.

    The same applies to actual Ponzi investment schemes. Had Madoff informed his clients that he was pyramiding investment dollars, he would not have been guilty of fraud under common law. The failure to notify is what makes Ponzi schemes a fraud.

    The article goes on to say:

    "Customers’ acceptance of interest paid by banks, or of “free” services offered by banks in lieu of interest, is an implicit recognition that customers are not warehousing assets, but allowing banks to act as their agents in lending out funds."

    I disagree. Unless the bank explains to its customers why it is able to offer "free" services, or interest on savings accounts without time deposit restrictions, it is engaging in fraud. The banks have habitually preyed on the ignorance of their customer base when it comes to such things.

    I have no problems with banks engaging in fractional reserve lending, just as I have no problems with brokers creating Ponzi schemes, as long as everyone involved is fully informed as to the risks associated with their investment activities.

    • avatar Martin Brock says:

      Bankruptcy is always a possibility, but a fractional reserve per se only places my liquidity at risk, not my savings. A Ponzi scheme is something else entirely.

      Why would people not be told of the risk? Even if acceptance of interest is not an implicit acceptance of the risk, I suppose free banks would have documents with fine print for depositors opening accounts. If you have no objection to fractional reserve banking as long as depositors sign such a document, what's the problem? You want a state regulator to require these declarations?

      Suppose I buy a house with a leaky roof, and the seller doesn't tell me about the leak. Is that fraud too? Suppose I buy a used car from you, and you don't tell me the radiator leaks? Suppose I buy a share of stock from you, and you don't first show me the "buyer beware" disclaimer on the prospectus? Do I get to jail you in these scenarios?

      • avatar michaelsuede says:

        "Suppose I buy a house with a leaky roof, and the seller doesn't tell me about the leak. Is that fraud too? "

        Not unless you tell the homeowner that there are no problems with the house. If you say there are no problems with the house, while knowing full well that the roof leaks, that is fraud. If you disclose the problems up front, then there is no fraud.

        Suppose I buy a used car from you, and you don't tell me the radiator leaks?

        Not unless you tell the car buyer that there are no problems with the car. If you say there are no problems with the car, while knowing full well that the radiator leaks, that is fraud. If you disclose the problems up front, then there is no fraud.

        Suppose I buy a share of stock from you, and you don't first show me the "buyer beware" disclaimer on the prospectus?

        If you lie about the financial performance of the company's stock which you are selling, then that is fraud.

        Do I get to jail you in these scenarios?

        Not necessarily jail, but I think a civil suit would be in order.

        • avatar Martin Brock says:

          Why assume that a fractional reserve bank lies more than any other business?

          • avatar michaelsuede says:

            Because the temptation to do so is far more prevalent.

            It's a lot harder to run a Ponzi scheme on your customers when your business is a restaurant. It's a lot easier when you are a bank.

            History makes it quite clear that bankers have a habit of downplaying investment risks when it comes to their depositors money.

            Again, I have no problems with fractional reserve banking - as long as everyone involved is fully informed about the risks it poses to their money.

    • avatar Bill Stepp says:

      Madoff was doing a lot more that was malem in se than simply running a pyramid scheme, like committing accounting fraud, comingling customers' funds, and stealing their money. The scheme he ran would have been fraudulent and illegal even had he informed them that he was pyramiding their money.

      Banks do in fact inform their customers that they can lose money, and anyone who isn't brain dead knows what can happen to their money. You seem to think that fractional reserve banking is a pyramid scheme. It isn't, despite the risk of bank runs, which are mainly the unintended results of State intervention in banking. There were few if any bank runs in true free banking systems, unlike regulated banks under centrally-planned banking.

      • avatar michaelsuede says:

        I don't care if there were no bank runs. Failure to disclose is fraud. If a bank is lending out depositors money without time-deposit requirements, it needs to inform its customers about the risks that are associated with that.

        And clearly, our present flavor of fractional reserve lending is a pyramid scheme. While I agree a gold backed free banking version is not a pyramid scheme, it is still a rather risky way of earning interest on your deposits.

  7. avatar Bill Stepp says:

    On a previous post by George Selgin, someone replied making a distinction between--so-called--"full reserve banks" and fractional reserve banks. The former are money warehouses and aren't banks at all because they don't engage in financial intermediation, which is what banks do. So Rothbard and his epigones were and still are wrong to refer to their imagined banks as banks.
    "Monstrous!" Banking was indeed a mystery to the author of The Mystery of Banking.

    • avatar joe bongiovanni says:

      I don't understand why you call full-reserve banking (a full-reserve bank) a money warehouse.
      Right now we have so-called fractional-reserve banking - but that term really applies to demand deposit balances against which reserves are held.
      All savings deposit balances are - by definition - fully reserved.
      And, being fully-reserved, the banks can, and do, lend them out.
      So the large majority (M2 - M1) of the money supply that banks use for lending is already fully reserved.
      Resort to full-reserve banking would brighten the line on demand deposits to what it was before deregulation.
      Since zero interest would be paid for demand deposits, the balance in M1 would likely decrease and the savings account balances increase accordingly.

      Writing on the subject of full-reserve central bank policy, author Irving Fisher had this to say about the advantages of "100 Percent Reserves".

      ""Money put into savings accounts would have the same status as it has now. It would belong unequivocally to the bank. In exchange for this money, the bank would give the right to repayment with interest - but no checking privilege.
      The Savings depositor has merely bought an investment, like an interest-bearing bond, and this investment would not require 100% (reserves), behind it any more than any other investment, such as bonds, or shares of stock""

      To wit: Full reserve banks do engage in financial intermediation.
      Thanks.

  8. avatar Floccina says:

    I will play the devil's advocate for a bit here even though I have come to accept and even see benefit in fractional reserve banking especially in a free banking system.

    I have heard critics of fractional reserve banking call it maturity transformation. In this case what is considered wrong and presumptuous is borrowing short and lending long. Demand deposits being the ultimate in short term borrowing.

    In a free banking world there is less presumption especially if an option cause exists. In that case bank issued money is not that different from checks written on demand deposit accounts.

    Never the less fractional reserve banking in combination with Government deposit insurance and a monopoly currency and a government central bank seems to make for some problems.

  9. avatar Bill Stepp says:

    Saying that fractional reserve banking in combo with government deposit insurance, a money crookopoly, and a government central bank makes for some problems is like saying that a healthy person who is tied up, held under water, and attacked by a shark has some problems. Yes he does!
    To go back to Madoff, if he had announced he was running a pyramid scheme, his investors would have demanded their funds back immediately. A FR bank is not a pyramid scheme, because banks keep enough reserves to meet their anticipated demands for customers' withdrawals. If banks' customers thought they were on the retail end of a Ponzi scheme, would they not immediately demand their funds back? Why don't they as a matter of course? Could it be because everyone understands that banks don't run a massive Ponzi scheme?

  10. avatar Paul Marks says:

    To Bill Stepp and others....

    Boom-busts will happen without the existence of "deposit insurance" or a Central Bank.

    There is a basic failure to understand (a "confusion" to use Kurt Shuler's word) what "fractional reserve banking" acutally is.

    It is NOT lending out (say) 90 Dollars for every 100 Dollars really saved (nine tenths), it is (for example) lending out 1000 Dollars for every 100 Dollars really saved (100 tenths). This is done by CREDIT EXPANSION - that is what a credit bubble a "boom" actually is.

    Without government intervention (such as Central Banking) this situation is indeed self correcting - but in a very brutal way.

    The malinvestment credit bubble "boom" is corrected by a BUST.

    And the process is NOT neutral - the economy is worse off (not the same - let alone better off) at the end of the boom-bust THAN IT WOULD HAVE BEEN had the boom-bust not occured. Also the process is not uniform - the people who are hurt most by the boom-bust tend to be the poor and unconnected politically.

    Of course government intervention (such as central banking) makes the credit-expansion bubble vastly BIGGER than it would have been (for example pre Federal Reserve bankers such as J.P. Morgan did not really lend out 100 credit-bubble "Dollars" for every 10 Dollars really saved - in those days it was more like 30 credit bubble "Dollars" for every 10 Dollars really saved).

    However, the basic principle that lending out Dollars that DO NOT EXIST creates a credit bubble (IS the credit bubble) and that, sooner or later, the bubble must burst - remains the same.

    Although (as I have said before) bankers CAN NOT create long term GRAND inflation.

    This is because the credit money boom is liquidated by the BUST - and "broad money" (bank credit - the credit bubble) sinks back down towards the monetary base.

    Only if the MONTERARY BASE is incresed (to "save the financial system" or whatever) can long term grand inflation be created.

    "But the Dollars that bankers lend out are not supposed to be Dollars - they are IOUs" (or whatever).

    That is not what the bankers say (not at all) - if they did say that then no one would accept their cheques and drafts and so on. The official legend is that the banks have real Dollars. Not "some" real Dollars - but every Dollar they claim their paper represents.

    So the system is actually based upon LIES - if you do not like the word "fraud". If people knew the truth about the banks they (the banks) would not last one working day - the whole system is based on keeping the truth (that lack even of enough fiat Dollars to cover the banker claims) away from the truth.

    I remember watching a man standing looking at a crowd of people withdrawing money from Northern Rock bank.

    He said (with contempt) "these people do not understand that Northern Rock has X billion Pounds worth of capital and reserves" - he said it with CONTEMPT for these foolish people taking money out of the bank.

    Actually HE WAS THE FOOL.

    The "capital and reserves" was (as it always is) magic pixie dust.

    Although the arch British banker-friend, Tim Congdon, carried on lying right to the end of Northern Rock (it was a "solid bank" and so on) - and did not even have the common decency to hang himself after the whole farce collapsed (he just blamed the Bamk of England for not giving Northern Rock enough Corporate Welfare).

    And it would be the same with J.P. Morgan Chase and the other banks - if the American Federal Reserve did not back them.

    Not just in the crises - but by the constant drip feed of "cheap money" [created from NOTHING] that has gone on for many DECADES

    But, from an economic point of view, the dishonesty involved in the system (and it is based upon dishonesty - on claiming things that the people claiming them know not to be true) DOES NOT MATTER.

    What matters (as writers from Richard Cantillon in the 1700s, to the "Currency School" of the early 19th century, to Ludwig Von Mises and others in the 20th century - have pointed out repeatedly) is that the credit money expansion creates a "boom" (IS the boom) - and that this boom must end in BUST.

    And, I repeat, that would still be true if the Federal Reserve (and so on) did not exist.

  11. avatar Paul Marks says:

    By the way - even if there is a Central Bank it does not automatically mean that it will back the credit bubble finance (the "boom" of bankers),

    For example it was the policy of the Bank of England for most of the Victorian period NOT to do so.

    Walter Bagehot (the third editor of the Economist magazine - and the author of "classic" works such as "The English Constitution", which is a great work to all those who have NOT read it) argued against the then Governor of the Bank of England on this very point.

    Of course Bagehot only wanted bailouts for some bankers - good ones who had lots of capital-and-reserves..... wiggle, wiggle, wiggle, jump and jive.

    Just like Bagehot did not want unlimited general welfare (as well as corporate welfare) - he just wanted to "concede whatever it is safe to concede" (pause while I throw up).

    Anyway leaving aside this vile person....

    In my home town of Kettering (England not Ohio - although it is just about as glamourous) a bank did go down - not saved by the Bank of England.

    It was not a limited liability bank so the owning family went down to.

    Did this mean that the children starved to death in the street?

    No it did not.

    One of the brothers became a leading architect the other a leading painter.

    The family name was "Gotch" - look up Alfred Gotch and Thomas Gotch. They did vastly more good in the world than they would have done if the family bank had been bailed out - and they had spent their lives playing with credit bubbles.

    "Buy Paul the manufacturing of the town was hit by the banking collapse".

    Not for long - the boot and shoe factories actually developed nicely over the long term in the 19th and early 20th centuries. As did the other manufacturing enterprises of the town.

    They did not NEED credit bubble finance - real savings (their own - profits, and the real savings of others) was enough for investment.

    The credit bubble antics of the big London (and other international) banks (and their boom-busts) was actually harmful (not benificial) to development.

    And these antics were tiny (mild) compared to what goes on today.

    As I have often said....

    If J. P. Morgan came back to this Earth he would (in spite of all his faults) be horrified by what is done by the bank that carries his name - and all the others.

    And, judgeing by the character of the man, blood would flow.

    Mr Morgan (and the other big bankers of his time) played wild games - but at the margin, their core business was still investing REAL SAVINGS (in spite of all the credit bubble stuff they ALSO did).

    Today there just is not a core business - not really.

    We do not have a international financial system with terrible credit-money bubbles in it.

    The entire system IS A BUBBLE.

    There is nothing much else there.

  12. avatar Paul Marks says:

    Remarkl

    "Are there no soft landings?".

    Sir if you really believe in "soft landings" (from grand scale credit bubble finance) then I have nice dragon to sell you.

    His name is George and he likes carrots. Send me ten thousand Dollars (in advance) and George the dragon is yours - presently he is hanging out with my "capital and reserves" (he likes magic pixie dust - as well as carrots).

    And I am NOT guilty of fraud as I have "no intention to decieve" - I really believe in George the dragon (and my "capital and reserves") and my shrink will so testify in court - if I remember to bribe him....

    After all someone engaged in credit bubble finance is "no more likely to lie" (Martin B.) than any ordinary businessman.

    Yes of course!

    There is no difference between someone producing something REAL (such as steel) and someone dealing in stuff that DOES NOT EXIST (such as "Dollars" that no one really saved - credit bubbles, book keeping tricks)??????

    Just because one's business is one big lie does not mean that one is dishonest in any way????????????????

    Still back to reality.....

    "I want to see EVIDENCE".

    Economics is not history - that a great BOOM (credit expansion) must (unless there is government intervention by expanding the monetary base) end in BUST, is a LOGICAL (not an historical) point.

    However, if you want history - then I will oblige you.

    How about the history of every credit bubble "boom" in every country in the world over the last TWO HUNDRED YEARS.

    That enough evidence for you?

  13. avatar Paul Marks says:

    "Fiat" money - this means "command" or "order" money ("fiat" - by fiat, take a look at Webster's or the Oxford E.D.)

    Bankers are INNOCENT of this particular offense.

    Private bankers can not say "use these bit of paper to pay your taxes, or I will send you to prison".

    Only governments can do that.

    So only governments are guilty of fiat money.

    Bankers (as I point out above) are also INNOCENT of long term grand inflation.

    They CAN NOT generate it - as their credit money "booms" are liquidated by the BUSTS.

    Only GOVERNMENTS (incluiding Central Banks) can create long term GRAND inflations - and they do this by increasing the MONETARY BASE.

    Although a standard reason they do this is to "support the financial system".

    I.E. to save credit-bubble bankers.

  14. avatar Paul Marks says:

    "Backed by" - there is the problem, right there.

    If gold is the money then gold is the money.

    If Federal Reserve notes are the money - then Federal Reserve notes are the money.

    "Backed".

    And "I.O.Us".

    Do not come into it.

    When gold is money then a banker says he is lending out gold - his paper is simply a way of carrying it "without damaging your pockets or getting drowned if you fall in a river".

    When Federal Reserve notes are the money (due to legal tender laws and tax requirements - fiat money having replaced gold or silver) then "of course" the banker has those Federal Reserve Dollar notes.

    He is just giving you a draft (or whatever) because it will be difficult to carry all those 100 Dollar bills (of course the government helps by getting rid of high demnomination notes - not that they are in on the scam or anything.......).

    There is no mention of him NOT having them - or even of "backing".

    The rationalisations are not the story that is presented to the customers.

  15. avatar Carlos Novais says:

    Slightly off-topic: Reserves on time deposits in 100%RB:

    100%RB accepting time-deposits must also manage reserves because of:

    - Maturity of credit longer than maturity on time deposits
    - Bad credit

    Consequences are: 100%RB must have 100% reserves to demand deposits plus reserves for maturing time deposits that turns (at maturity) into demand deposits (not covered by similar maturity in its credit portfolio).

    This could well be an incentive for practicing FRB.

    In fact it has been defended that bubbles are still possible if 100%RBanks extend maturity longer than its funding.

    But even this points does not explain why hoarders will deposit physical gold in a FRB instead of warehouse, taking into account that receiving interest for demand deposits comes at the price of turning tis gold in a credit risk claim.

  16. avatar Carlos Novais says:

    Rothbard:

    "A second, and more lasting, intervention was the National Banking Acts of 1863, 1864, and 1865, which destroyed the issue of bank notes by state-chartered (or "state") banks by a prohibitory tax, and then monopolized the issue of bank notes in the hands of a few large, federally chartered "national banks," mainly centered on Wall Street. In a typical cartelization, national banks were compelled by law to accept each other's notes and demand deposits at par, negating the process by which the free market had previously been discounting the notes and deposits of shaky and inflationary banks."

    Interesting: "In a typical cartelization, national banks were compelled by law to accept each other's notes and demand deposits at par"

  17. avatar joe bongiovanni says:

    I don't believe you're showing a clear and complete picture of full-reserve banking and lending.
    Readers should pursue Fisher's Central Bank texts on 100 Percent Money.

    ""A 100% reserve bank would be a kind of warehouse. ....Because 100% reserves preclude lending funds out at interest, a 100% reserve bank would have to charge storage fees just as banks do for safe deposit boxes. Customers’ acceptance of interest paid by banks, ... is an implicit recognition that customers are not warehousing assets, but allowing banks to act as their agents in lending out funds.""

    Only the checkbook(demand-deposit) money would be warehoused.
    Once changed to 100 Percent reserves, ALL banks would distinguish between the demand-deposit and savings-deposit functions - charging depositors for one and paying depositors for the other; one held at fee without risk and always available to the depositor, and one providing funds for lending for a term-certain.

    While banks would return to banking, it is not true that 100 percent reserves precludes lending at all.
    All savings/investment deposits are funds available for lending. ( M2 minus M1)

    Rather than 100 Percent Reserves precluding banks lending funds out at interest, I believe that today about $7.7 TRILLION would be available for lending.
    Not precluded by anything.

    Thanks.

  18. avatar Martin Brock says:

    You own valuable, durable, easily identifiable and distinguishable property, and you need money. You register this property with the title registry after paying the requisite fees for appraisal and such. You may now issue notes entitling the bearer to a portion of the rental value of your property. The total value of these notes may not exceed a fraction, say 80%, of the appraised value of your property.

    People generally accept these notes in trade, because everyone knows about the title registry and may easily verify that a particular note is backed by adequate collateral. The registry is a public record and radically transparent. Anyone at any time may verify any recorded title with his own due diligence. Because people generally accept the notes, they are money.

    This arrangement is equivalent to having a line of credit secured by your equity in your house, but it requires no central bank. It hardly requires a bank at all.

    A note referencing this title registry always has a verifiable value, and this value does not change unless the value of collateral backing the note falls more than than the par value of all notes referencing it.

    Since the value of collateral is variable, a particular note could belong to an insurance pool. All of the collateral in the pool backs all of the notes in the pool, so notes lose value only if the value of all collateral in the pool falls below the par value of all notes in the pool. If people prefer notes pooled this way, then you'll also choose an insurance pool when registering your collateral. This pool is similar to a bank. A central bank forces everyone into single pool.

    You could choose a pool that only accepts collateral of a particular sort, like housing or gold or silver secured in a vault or Bitcoins. If your pool only accepts gold in vaults, and if your standard of value is gold, your pool is a Rothbardian, 100% reserve bank.

    "Appraisal" implies a price, so the title registry requires a pricing mechanism, like a commodity as a standard of value. With a standard of value, the "price" of a good is the quanity of the standard that people freely exchange for the good.

    If gold is this standard of value, the value of a note backed by gold does not vary with the changing value of collateral, because the price of gold in gold never changes; however, other prices need not be so stable. If demand for gold rises, the price of gold does not rise with it, so the price of everything else falls. Because gold is easily hoarded (by armed men monopolizing force for example) and the supply of gold is inelastic, this problem can be acute, because countless contracts use these prices.

    Gold need not be the standard of value. People may prefer a less conventional standard, like Bitcoin or milk. If gold is not the standard, the price of gold backing notes can rise or fall, like the price of houses and other collateral.

    The standard of value is a commodity, but it is not generally the collateral backing notes. The standard need not be bankable at all, because it need not be durable. I argue elsewhere that the standard should be common rather than scarce, non-durable rather than durable and have an elastic supply rather than inelastic supply.

    In other words, the standard should have all of the qualities that gold does not have. Gold may be useful as collateral in this monetary system, but it is not useful as the standard of value, the good with a fixed price relative to which all other prices are measured by the market.

    If "dollar" names the unit of value for expressing prices, the choosing a standard of value fixes the price of a unit of this commodity in dollars. The standard price of an ounce of gold could be $35 or the standard price of a quart milk could be $1.

    When you register your property with the title registry and issue a $1 note, you agree to pay rent on $1 worth of the property to anyone accepting the note in trade and informing you of their intention to hold the note, by "depositing" the note in your bank for example. While the note is deposited in your bank, its holder does not spend it but does collect a portion of the rent that you pay on collateral backing the note. Collateral pooled together pays the same rent, all else being equal.

    With this understanding of a monetary system, what is the meaning of "fractional reserve banking is fraud"? A note backed by collateral other than gold is nonetheless backed by collateral more valuable than the note, unless the value of the collateral falls more than the par value of the notes it backs.

    If the standard of value is not gold, a pool of gold backing notes differs little from a pool of other collateral backing notes. The price of gold varies, so the value of notes backed by gold can vary, even if the notes are warehouse receipts, so the "fraud" argument applies to these warehouse receipts as well. The "fraud" argument seems to assume that the standard is gold and that anyone preferring another standard is part of a criminal conspiracy.

  19. avatar Vigilance says:

    Thanks for the article! I just stumbled onto this website, and it's the first I've seen that talks about what fractional banking actually is - as opposed to the pure anti-fractional reserve banking hate speech I've become so accustom to.

    Below is a FB comment I posted several months ago in response to someone wildly bashing fractional reserve banking. I had to make it all up (with careful consideration, of course), because before today I'd never seen anyone properly explain it.

    I think I understand how fractional reserve banking works, but maybe someone can tell me if I explained this right (or where I'm wrong). Thanks!

    ----

    I'm not convinced that fractional reserve banking (recirculation of existing money) by itself is inherently bad, as it seems like a valid practice for any bank when dealing with sound money. The problem I see is when a central bank can create new currency out of nothing, and then other banks fractionally lend that artificial currency -- that's where it goes bad.

    For example: Let's say you give me 10 gold coins to hold for you, and I lend 8 of them to another friend. I am maintaining a "reserve" of 2 coins and lent out the rest, but we haven't created any new money. We've merely recirculated existing money, and I believe this method would be necessary to keep a sound-money economy moving.

    On the other hand, let's say you write "$1" on 10 pieces of toilet paper and I hold them for you, then lend 8 of those to a friend who thinks it's real money. In this case, we are indeed amplifying this deceptive currency that we created.

    Thus, fractional reserve banking is not the source of our monetary issues, but it definitely exacerbates the situation when we're dealing with fiat currencies! Hence, the root is our fiat currency. If we could move to sound money, we might be amazed at how many painful economic symptoms vanish.

    Another way to put it is that fractional reserve banking is like medication. Under normal circumstances it's beneficial, but when mixed with alcohol or drugs (fiat currencies) it can be deadly.

    That's how I understand it anyway. Cheers!

  20. avatar Paul Marks says:

    Well Irving Fisher (the economist Joe B. cites) had a terrible record.

    He was astonished by the bust of 1921 (widly predicted by Austrian School economists) and was astonished again by the bust of 1929 (also widly predicted by Austrian School economists). And carried on saying that everything would soon be fine - even as things fell apart around him (a total denial of reality).

    Yet I thought it was "mainstreamers" (as you call yourselves the "mainstream" - and anyone who has a different opinion, even if they were writing about economics before you, not the "mainstream") who were "empirical" and the Austrian School that was not?

    "Empirical" economists who keep get their predictions wrong (indeed even AFTER the crash of 1929 still go about saying all will be well) are on weak ground.

    However, Irving Fisher (and Joe B.) does have a point.

    Banks lending out more money than has REALLY BEEEN SAVED is rather dubious. We must remember what "fractional reserve banking" really means.

    It does NOT mean taking in (say) one billion Dollars of real savings and lending out 900 million Dollars (keeping 100 million Dollars as a "ten percent fractional reserve"). Quite the contrary.

    What "fractional reserve banking" really means is, for example, taking in one billion Dollars of real savings - and then lending out ten Billion Dollars (or a hundred billion Dollars).

    This process would be better described as "credit bubble building" rather than "fractional reserve banking".

    However, the General Peron style "cure" (have the government produce more money on top of real savings - rather than the banks) is worse than the sickness. Argentia went from living standards on a par with Canada - right down to the Third World. And so have so many other countries that have tried Joe B. style printing press economics.

    Governments should finance their spending by taxation (not the printing press - as General Peron, and Joe B., favour).

    And money lenders should lend out real savings (their own - or the real savings that other people entrust to them), not credit bubbles.

    Although (before anyone points it out) I fully accept that the law may not be able to make bankers restrict themselves to real savings - as bankers (going back to the Peel's Act of 1844) have shown themselves very good at getting round restrictions.

    Better to let the fear of BANKRUPTCY act to limit banker antics.

    If both bankers and DEPOSITORS are told (very clearly) that there will be NO BAILOUTS and that banks will really go bankrupt - and (most important of all) DEPOSITORS WILL LOSE THEIR MONEY, then we will see much more careful depositors - and much more careful bankers (if they do not clearly show how sound their bank is they will not attract depositors).

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