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The Problem is Central Banking not Fractional Reserve Banking

Back in December, I used one of my weekly Freeman Online columns to address what I saw as a common misunderstanding of how fractional reserve banking works, at least among many who comment on various Internet sites devoted to Austrian economics, especially ones critical of fractional reserve banking.  Below, I reprint that column with a few minor changes.  Interested readers might also wade through the (70!) comments on the original column if they wish to explore this issue in more detail.


In some free-market circles fractional reserve banking (FRB) is blamed for everything from business cycles to bad breath.  Defenders are seen as apologists for inflation and fraud.  Thankfully these views remain a minority because they are gravely mistaken.  As I, and other Austrian monetary theorists, such as George Selgin and Larry White, have argued, there’s nothing wrong with FRB that getting rid of a central bank can’t cure.  Fractional reserve banking works just fine in a free market.

I don’t want to rehearse the whole debate in this column, but I do want to address a claim made by opponents of FRB.  They often say something like: “If I deposit $1,000 in my bank and it has to hold only 10 percent reserves, it can create $10,000 in new money.”  This claim is ambiguous at best and downright wrong at worst. As stated it betrays a lack of understanding how fractional reserve banks (whether under free or central banking) actually work.  Let's assume we have a fractional reserve banking system in which banks face a 10 percent reserve requirement.  (Note now that we are not talking about a free banking system – I want to make a point about fractional reserve systems in general and show how the problem is that the system isn't free, not that it's based on fractional reserves.)

First of all, this claim is ambiguous about where the deposit comes from and what it consists of.  For example, if I deposit a $1,000 check in my bank that you’ve written on your bank, what happens?  It’s true that my bank gets $1,000 in new reserves, but it cannot create $10,000 in new loans with the money.  Why not?  Imagine it credited $10,000 to the borrowers’ accounts.  What would they then do?  They would spend it because that’s why people borrow money!  And what happens when it’s spent?  The banks in which the funds are eventually deposited ask the original bank for $10,000 in reserves.

The problem is that if the bank was at its 10 percent requirement before the $1,000 deposit came in, it cannot lose $10,000 in reserves without falling below its minimum requirement (or its desired level, in a free-banking system with no such requirement, which would be unacceptably risky without deposit insurance).  What can the original bank afford to lose?  Well, it has my new deposit of $1,000 against which it has to keep 10 percent, or $100.  Therefore it has $900 to loan out.  And that’s all.  As I call it when I teach "Money and Banking," this is Banking Rule #1: No individual bank can lend more than its excess reserves, in this case $900.

Now you say, “Yes, but that $900 will be spent and deposited at another bank, which will keep $90 and lend out $810, and so on.”  And you are quite right, which leads us to Banking Rule #2:  The banking system can expand by a multiple of those original excess reserves.  Assuming 1) all banks face a 10 percent requirement, 2) no one takes wants outside money, and 3) no banks hold excess reserves, the system will create $10,000 based on that original $1,000 deposit.  So perhaps the problem with the original statement is that it focused on one bank only rather than the banking system as a whole.

But this is hardly the whole story — and we need the help of our old friend Monsieur Bastiat to see the unseen.  If the $1,000 I deposited came from your bank, it loses the $1,000 in reserves transferred to my bank.  That forces your bank to call in loans to make up the lost reserves, which leads to reserves being lost by other banks, which then have to do the same thing.  The result is that the $10,000 created by my bank’s gain in reserves is canceled by the $10,000 destroyed by your bank losing those reserves.  When you write a check to me and I deposit it, there is no bank multiplier on net (assuming the three conditions above hold). Thus we see the reverse of Banking Rule #2, as the system simultaneously contracts by a multiplied amount of the original deposit/withdrawal.

So how does new money ever get created and multiplied on net?  By injections of new reserves.  Only one entity can create new reserves on net in a fiat money system with a central bank:  the central bank.  When the Fed conducts open-market operations it adds new net reserves to the system, which enables the money-multiplier process with no offsetting loss in reserves elsewhere.  The central bank and only the central bank can do this.

A clever fellow might now say, “Well, what if I deposit currency into my bank?  There’s no offset then, right?”  That is indeed true.  But where did the currency come from?  At some point, you or someone else had to withdraw it from the banking system, which caused a multiplied contraction in the total money supply because currency counts as reserves.  The two halves of the process are separated in time, unlike with the deposits, but the net effect in the long run is still zero.

Injections of new currency can cause the money-multiplier process, but guess what is the only thing that can create new currency in a system with a monopoly central bank?  You got it:  the central bank. If you want to know whom to blame for setting off the money-multiplier process, you need only look there.  The monetary base, which corresponds to the total level of potential bank reserves (being the sum of the total supply of currency plus the the supply of bank deposits at the Fed), is totally under the control of the central bank.  No one else can create currency and no one else can create net additions to the total amount of deposits at the Fed.

As Robert Higgs points out in a recent blog post, for increases in the monetary base to become increases in the supply of money, the banks have to cooperate by lending out their excess reserves.  Banking Rule #1 does not say that fractional reserve banks must lend out their excess reserves, only that they cannot lend more than their excess reserves.  Higgs argued in an earlier post that the reluctance of banks to lend out those excess reserves is what is preventing the remarkable increase in the monetary base since the fall of 2008 from turning into significant inflation.  Factors such as the Fed choosing to pay interest on bank reserve deposits, the large cash holdings of big firms, and the persistent regime uncertainty that makes lending/investing seem particularly risky these days can together explain the reluctance of the banks to turn the monetary base into money via the multiplier process.  Still, it remains the case that only the central bank is responsible for the expansion of that base, even if the banks balk at lending it.

But what about free banking?

In a free banking system, matters are a little bit different.  Two factors can, effectively, change the ability of the banking system to initiate that multiplier process.  Changes in the supply of the outside money are one such factor.  In a commodity-backed free banking system, an influx of that commodity into the banking system brings in reserves and enables the banking system to expand.  On the margin, however, the quantity of new commodity money entering such systems will be small compared to the total supply of the commodity in any given period of time.  In practice, this has not posed an inflationary problem for (mostly) free banking systems.

Second, in a free banking system, the reserve ratio is determined by the banks themselves, not by the central bank.  The ratio need not be treated as an exogenous variable.  Free banks can lower their desired reserve ratios which will enable them to create more liabilities off of a given amount of outside money.  And it is here that we move from the mechanics of banking to the thornier theoretical issues.  If free banks see an opportunity to safely reduce their reserve ratios to enhance their profitability, it's likely because they have perceived that the demand to hold their liabilities has increased, reducing the demand for their reserves via inter-bank and over-the-counter redemption.  With fewer claims being made on their reserves, some of their reserves that were previously "desired reserves" are now seen as "excess reserves," and Banking Rule #1 is in play:  these now excess reserves can be lent out in the form of a larger supply of bank liabilities (most likely in the form of new deposits granted to borrowers).

From a monetary-theoretic perspective, if free banks create more liabilities when the demand to hold those liabilities has increased, the results will not be inflationary, rather this warranted increase in the total money supply will prevent a deflationary excess demand for money from setting in.  The increased demand to hold the bank's liabilities (i.e., the falling demand for its reserves), is a form of savings that drives down the natural rate of interest.  When the free bank responds by lowering the market rate it charges to attract the marginal potential borrower on the demand for loanable funds curve, it is not inflating but maintaining the all-important Wicksellian coordination of the market and natural rates of interest.  So even if free banks do start to create more money by lowering their desired reserve ratios, this decision faces the test of profit and loss in the marketplace, which will determine if the entrepreneurial judgment of the bankers is correct.

The bottom line is that it is not fractional reserve banking per se that is the cause of inflationary increases to the money supply due to the money multiplier process but rather the ability of central banks to override market signals, thanks to their monopoly status, and add reserves to the banking system at their discretion and independently of the public's preferences.  Again, there's nothing wrong with fractional reserve banking that getting rid of the central bank and other government interventions wouldn't cure.

  • The problem is:

    -In real terms: Investment (or even general spending) without previous voluntary monetary saving or incurring in a marginal cost for issuing new money (as mining gold or silver).

    – But in contractual terms there is an open question for me:

    * 100% reserve certificates/notes/demand deposits (of whatever commodity is chosen by people as a medium of exchange) should be labelled as such.

    * Fractional certificates/notes/demand deposits should be clearly labelled as promises of payment/delivery which then could circulate and be part of contracts

    This means that any debtor/creditor contract would define if the contract could be settled in “money [specie or substitute of specie which constitutes 100% reserves]” or “promises of payment” issued by a credible issuer (no doubt).

    I think this proposal would settle the dispute between both camps.

    I tend to think that the fractional reserve one defends that such labelling requirement is something not meaningful and that the market spontaneously would require it or not. The 100% reserve faction should defend this requirement as natural law requirement.

    • David Johnson

      Both types are notes are still promises to exchange deposits for notes. How the deposits are stored is of interest only to the depositor, while the user of the note only cares that he can redeem the note. Such note labeling requirements are unwarranted.

      • RickDiMare

        David, I probably comment too much in this blog, but to a Uniform Commercial Code (UCC) lawyer, which I am not, the "note labeling" you mention is a big deal.

        It would be nice if a UCC Title 3 negotiable-instruments lawyer would join in here to confirm, but assuming the specie note is authentic, a Treasury Demand Note or Treasury Coin Note that is "redeemable on demand" historically has been legal tender "in payment of" debts, whereas, as Carlos states above, notes that are not redeemable for specie are empty "promises of payment" that only effect a payment "for" debt.

        • David Johnson

          By "note labeling" I meant Carlos' suggestion that notes be specially labeled if they come from a fractional reserve bank. Historically notes from fractional reserve banks HAVE been accepted for payments of debt. They were not considered mere promises. They were redeemable on demand.

          While there may be marketing reasons for it, I see no legal reason why banks should be coerced into labeling their notes as coming from either a 100% or less than 100% reserve bank.

    • RalphMusgrave

      Carlos, I agree that FRB appears to involve spending with no corresponding foregone consumption (if that’s what you are saying). However, I suggest that such foregone consumption DOES take place, but in an erratic or illogical manner.

      To illustrate, assume borrowing from banks rises, and the money is spent. If the economy is at capacity, government will then have to rein in demand somewhere else. If it raises interest rates, that’s not too bad: after all, increased demand for borrowed money leading to a rise in interest rates is kind of logical. But government might just as easily rein in demand by cutting spending on say schools and roads. Now that is totally illogical.

      Re your suggestion that 100% reserve accounts be clearly labelled as such, and that FRB accounts are also labelled, this is exactly what is proposed in a paper by Prof R.A.Werner (URL below). He also argues that the 100% reserve accounts get no interest but are 100% safe and are taxpayer backed. In contrast, the money in FRB accounts is invested in commercial ventures, and get more interest, but are not taxpayer backed. I agree with that.

      • Many thanks for the reference.

        I posted several related comments (defending the legal and labelling differentiation between 100% reserves titles and fractional reserve ones) on "The flaws in fractional reserve and maturity transformation" at Cobdencentre:

        "It must be realized that the all purpose of 100% reserve titles (notes or demand deposits) is to be completely free of issuing credit risks, making the title as good as the specie (gold, silver, or whatever asset constitutes a medium of exchange chosen by the market) itself.

        It’s easy to understand the self-interest of fractional reserve issuers to have its “promises of payment” titles to be fungible or exchangeable at par value as the specie.

        It would be stupid for pure warehouses to let fractional reserve issuers to let its titles be perceived as exactly the same contract as a pure warehouse title (were a commission must be charged for warehouse keeping)."

        In the last two I’m arguing a smooth transition:

        "In the end, Central Banks and the all monetary system act as deposits really had 100% reserves because… every time there is a crises, reserves are created for the sake of 100% deposits to be safe.

        I would argue that in the present fiat money system we would gain from:

        1. Central Banks would issue all the reserves required for all the demand deposits to have 100% reserves. Then, no more credit expansion by money creation would be possible.

        2. New money would enter the economy through the monetizing of deficits (no public debt in banks balance sheets financed indirectly by central banks at a lower rate: a pure monetizing profit that banks collect).

        Step 2 is inflationary? Good. It would be much better to have an inflationary process that is easily detected by Prices on Consumer that having Business Cycles through the process of artificially lowering interest rates creating price booms in non-consumer related goods. Inflation on consumer prices are easy to detect and public understands that and react to it, asset inflation through credit creation is not understood or accepted as such not even by many economists."


        "My suggestion for 100% reserves in the present fiat money system is to bring stability to the banking system in terms of demand deposits and avoid great business cycles induced by artificial low rates.

        New money created to pay for deficits is very inflationary, so its effects are indeed more visible (as in the70′s?):

        – Deficits itself are subject to public scrutiny
        – CPI is also felt publicly.

        So, I would recommend this and at the same time allowing for gold and silver to circulate as money (and 100% reserves certificates). This would insure a more stable transition.

        Any other scenario for a transition seems to me very chaotic.”

        • RickDiMare

          Carlos, I would like to agree with you here, but also mention that differentiating between fractional and full reserve bank accounts is meaningless unless we cultivate a network of lawyers who understand the difference and will enforce, not only against banks, but against the government as well.

          Imagine that you have two homes in a neighborhood. One home is known for leaving the doors unlocked and allowing neighborhood kids to come and go as they please, but the other home keeps doors closed and locked. There is not likely to be any legal cause of action against kids entering the first home, i.e., accounts subject to fractional reserve practices (and a regulatory income tax). However, any attempt to enter the latter home constitutes a trespass and the crime of "breaking and entering." (There is "entry" by kids in the first home, whether or not explicit permission to enter is given, but no "breaking," so there is no crime.)

          Chances are that the people interested in this blog want to keep their doors and windows locked, so this is a good place to start making the important distinction between money to which title has been claimed by the depositor vs. money to which the depositor has allowed gov't and bankers to access.

  • RickDiMare

    Steve, it's only because of a failure of the U.S. legal system that it appears "no one else [but the central bank] can create currency," and this in turn leads to the appearance that there's no way to avoid "setting off the money-multiplier process."

    New money, as Bastiat would agree, is supposed to enter the banking system as PROPERTY through our wages and salaries, but again, try to find a lawyer who understands this.

    It's really a shame because only under U.S. law is it possible to inject money into the economy directly through labor, and that's because of our unique historical experience in dealing with with pro- vs. anti-slavery states during formation of the U.S. Constitution.

    Hopefully discussions like this will serve to wake up the lawyers.

  • Mike Sproul

    Deposit money at private banks is like a call option on the base money created by the central bank (with a strike of zero and no expiration). The issuance of call options on GM stock does not affect GM's assets or liabilities, and therefore it does not affect the value of GM stock. In the same way, Wells Fargo's creation of checking account dollars does not affect the Fed's assets or liabilities, and so does not affect the value of Fed-issued dollars.

    As for stock itself, when GM issues new shares, it normally gets equal-valued assets in exchange. GM's ratio of assets to shares is thus unaffected, and the value of GM stock stays the same. In the same way, the Fed normally gets a dollar's worth of assets when it issues new dollars, so the Fed's creation of money is normally not inflationary either.

    It's a pretty good analogy: Base money is valued like base stock, and derivative money is valued like derivative stocks.

    • Very good analogy. This is the proper way to think about bank money, as a financial derivative on base money.

      • RickDiMare

        Mike, I don't know about stocks and call options, but your analogy sounds good.

        However, when dealing with legal complexities surrounding the U.S. monetary system, I think the word "base money" is too general because it's usually comprised of both the "derivative" (central bank) money you mention, as well as two kinds of money issued by the "sovereign" (Congress).

        So, in addition to the term "base money," I think we need to add terms like SOVEREIGN BASE MONEY and COIN BASE MONEY.

        SOVEREIGN BASE MONEY includes coin, paper or electronic money issued directly by the Treasury Department. Only Congress should have the right to expand this currency (but regarding coin, Congress can only expand by changing metal type or content). If banks subject this money to the "multiplier process," it should be at the personal risk of its stockholders and officers, and if necessary, the Treasury Department should "pierce the corporate veil," discipline the bank, withdraw the charter, immediately attach shareholder assets, etc. In effect, when banks handle SOVEREIGN BASE MONEY they are acting as "fiscal agent" of the Treasury Department, not as independent privately-owned banks.

        COIN BASE MONEY cannot be subject to the multiplier process, even by Congress, and includes money to which depositors have claimed title. Banks who loan out this money also take on personal risk, and in addition to the Treasury Department having the right to pierce the corporate veil, the depositor also should have the right.

        We might also add a term like NON-SOVEREIGN BASE MONEY to refer to base money that can legally be expanded and subjected to fractional reserve practices, i.e., the money-multiplier process.

        • Mike Sproul

          Yes; all money is either a commodity itself (the only pure "base money") or else a claim to some commodity. So if a private bank issues bits of paper that say "IOU 1 oz. of silver" (and calls them pesos), then that's derivative money. If the government then issues deposit accounts that give a claim to so many paper pesos, then that's derivative money too (technically, derivative-derivative money). It's possible that nobody trades with actual silver, and in this case all money in actual use would be derivative money.

          • RickDiMare

            Historically, though, it does seem that the Treasury Department has issued a paper money that represents real Constitutionally coined money, and that seems to be when the note is redeemable on demand, i.e., when the paper represents legal title to coined money. Using your example above, a piece of paper that says "IOU 1 oz. of silver" (with no time certain for payment) is quite different than "IOU 1 oz. of silver on demand at any U.S. bank." (But I don't want to confuse people by letting them think they can only avoid derivative money if the coin is made of precious metals. The legal effect of really being able to own and control one's money is the main thing, not what metal the coin is made of.)

            At some point after the Panic of 1907, Congress appears to have realized it couldn't control the numerous ingenious ways the market had of formulated derivative money and payment systems, so Congress in turn did something ingenious in 1937 by levying an income tax on (the "incoming transfer" of) derivative money, a kind of indirect way of controlling the money supply without actually issuing money itself. As long as it could control derivatives through taxation (which, by the way, is Constitutional when the depositor is not claiming title to his/her money), then Congress could let the market and the Federal Reserve invent all the derivatives it wanted to.

        • Mohamed

          it's not the Treasury department who issue money, it's the Fed (in the case of the US), and central banks in the case of the rest of the world.
          the Treasury department issue a BOND, which is a promissionary note to pay the principale+interest, then the Fed order its presses to print money for you out of thin air. so your "money" is actually a "debt".
          the Fed is a private-for profit entity which is not federal (not american).
          if the you own a country where the Treasury department want to issue your own money (debt-free), you will soon have a war knocking at your doors like what happened to Afghanistan, Iraq, Libya, and what will happen to Iran and China if they don't "cooperate".

  • What are in fact Reserves in our actual Central Banking world?

    As this crisis demonstrates, any time a general lack of reserves takes place (and a general banking default is pending)… Central Banks issue all the reserves required.

    And in the booming phase, banks get the reserves required for the expanding of credit and deposits.

    Additionally, as the present EU problem with Greece shows, banks possessing public debt create the excuse for Central Banks to monetize public debt in order for those holdings not to be booked as a default.

    So, seeing bank money actually gives a put option on Central Banks to issue more reserves to cover reserve needs or let the banks default.

    This is a rotten system, and this differentiation of money between reserves and banking money perceived by a few but not the general public have its origin on non differentiation between specie and 100% reserve certificates/notes/demand deposits and fractional reserves titles.

    My opinion is that such differentiation in labelling (meaning contract clarity) is mandatory from natural law analysis (we can add pure utilitarian reasons).

  • David Johnson: "While there may be marketing reasons for it, I see no legal reason why banks should be coerced into labeling their notes as coming from either a 100% or less than 100% reserve bank."

    But can something be issued, labelled and placed in the market (just remember securities laws) as a civil deposit (something that exists in civil codes of law) being a “promise of payment” issued?

    For sure, the contractual underlying must be different.

    If people want to exchange it at par, that is ok, but even from general accounting good rules, both must be different items in the balance sheet.

  • Aloha!!

    Great article and this goes a long way to explain the differences. It is becoming obvious to one and all, even some of the Joe Six Packs that something is wrong here with so much debt. We were just getting used to the word BILLIONS on the financial media and now we're way into the word TRILLIONS.

    Granted a central bank is a monopoly but so is the two party system that has dominated Congress for 100 years that created by law the Federal Reserve. Of course it is a symbiotic parasitic monetary system for sure with money backed by the "human condition". Never mind IN GOD WE TRUST since God has nothing to do with monopolies! Give a Middle Class citizen a blank check and they will make it out for $1,000,000, but give a ivy league trained banker a blank check and they will make it out for $700BIL! That's the human condition, human action in action, so to speak!

    Still the true problem is Congress's US TREASURY. While they debate the debt ceiling and speak of cutting $2TRIL in spending by 2021(ten years) according to the US Treasury Statement for June 24th the Treasury reports $2.44TRIL in gross outlays ($1.63TRIL in net outlays) since Geithner warned Congress in his letter about the debt ceiling back on April 4th. The monetary absurdity of spending $2.44TRIL in 60 working days(2 months) while debating $2TRIL in cuts by 2021 on CSPAN is nothing more than Money Theater!

    Naturally the US Treasury makes the US FED's balance sheet look like Romper Room! These are real monies injected into the economy every single working day. Some goes to Defense Vendors for War(highly inflationary) and a multitude of Fortune 500s and some goes to feed 46 million Americans who can no longer afford food. Think about "46 million" a second! That is twice the population of Australia that cannot eat here in America, the Home of the Free and the Brave. There's more than enough monetary expansion going on at the US Treasury on a daily basis. In fact the US Treasury's daily QE makes Bernanke look like an amateur!

    But … it is what it is!

  • RalphMusgrave

    Steve Horowitz, I agree that most of the arguments against FRB are flawed (bad breath, fraud, etc). However, I suggest your arguments have flaws, as follows.

    The main accusation made by the more clued up opponents of FRB is that it promotes instability, e.g. see paper by Prof R.A.Werner & others here:

    This instability derives from two sources. First, where commercial banks adhere to voluntary or legal reserve requirements, they do not make full use of their reserves all the time. For example US banks currently have a massive $1.5tr of excess reserves. Thus given a rise in consumer or business confidence, these banks will make the upturn more precipitous than it would otherwise be. And conversely, the downturns are more precipitous when they come: witness the current deleveraging.

    There might seem to be a flaw in the latter argument namely that the US bank system for a long time had zero excess reserves. But this was essentially a “fiddle”. That is, reserves at that time paid no interest, so rather than hold any excess reserves, banks held anything that paid some interest and could be turned into reserves at will: government debt primarily. Put another way, faced with lending opportunities that looked like yielding more than government debt, the commercial bank system just sold government debt and went ahead and lent.

    The second source of instability is thus. What banks do essentially is to create and trade debt. But this process has been going on for thousands of years, and all without the assistance of central banks, AND without the backing of any physical commodity, like gold in many cases. To a large extent, this debt trading was done with tally sticks. For info on this, see:

    Put another way, if the Fed for some strange reason ceased to exist, commercial banks would carry on pretty much as if nothing had happened.

    All of which leads to the question as to what extent commercial banks currently act as if their central bank didn’t exist? My answer is that in a boom, they create money or credit much as they please because, for example, based on over-valued property prices, it seems profitable. As regards the deposits each bank needs, that comes from other banks – mainly created out of thin air. As to legally imposed reserve requirements, if they exist, the central bank is FORCED to supply extra reserves, because if it doesn’t, demand for borrowed money will force interest rates above the central bank’s desired rate or base rate.

    One of the main proponents of this view of things (i.e. that the commercial bank tail wags the central bank dog during a boom) is Steve Keen, an Australian Prof of economics. And assuming this view of things is valid, this is a second source of instability that derives from FRB.

    Third, the bank system as currently operated both in the US and other countries involves the use of money in 100% safe and taxpayer backed accounts for commercial purposes. This is plain wrong. It enables those account holders to gain the advantage of commercial activity (a rate of interest that his higher than it otherwise would be) without taking a risk. It amounts to a taxpayer funded subsidy of commerce.

    The way to rectify this flaw, as Prof. Werner points out, is to have 100% safe accounts, but stipulate that money in such accounts can only be invested in a 100% safe way, and that means monetary base (which normally pays no interest).

    It is moot as to whether the latter charctristic is a characteristic of FRB, or whether it is a “stand alone” characteristic. But it is certainly closely associated with FRB, as Mervyn King, governor of the Bank of England pointed out in a quote on p.4 of the Werner paper. The reason for this close association is thus.

    If we disallow the use of money in 100% safe accounts for commercial purposes, and ensure that such money is invested in 100% safe investments, the only suitable investment is monetary base. Even government securities are not good enough because they can lose value. Plus monetary base normally pays no interest.
    Thus there is no point in a bank operating a 100% safe account in gearing up FRB style: they won’t earn any more interest. Ergo, 100% safe accounts almost by definition cannot involve any FRB. Indeed, under Prof Werner’s proposals, they don’t.

  • robread

    Just in case this thread is still being monitored I have an observation on Steve's Banking Rule #2 that I am hoping someone can clarify/validate.

    The rule states "The banking system can expand by a multiple of those original excess reserves".

    It strikes me that while the multiplier is specific to FRB – the pyramiding of loans on top of the monetary base would be present under 100% reserve banking as well. For example – $1000 paid into a 100% reserve bank money market account (where the lender agrees to give up his claim on the money for a period of time) is lent out to a business which spends the money with a supplier who banks the money into his bank. As it is a 100% reserve system that bank then can (assuming the supplier also agrees to give up his claim on the money for a fixed time) be lent out again. This cycle could go round a few times and build a pyramid of loans all backed by a 100% reserve but in total way more than the amount of commodity money available.

    This scenario would differ from FRB in that the total claims on the money at any point in time would never be greater than the amount of commodity money available (and would not therefore affect the broader money supply), but (in theory at least) the pyramid could be much bigger than FRB because no reserve requirement wold be needed. (Of course I realize that in reality the need to keep cash reserves would limit the amount of money available for the loan-pool under 100% reserve , and the lack of this limitation under FRB is one of its optimizations).

    Can someone confirm that that is how loans under 100% reserve would work , or are there more restrictions on the ability to loan than in my example?

    If I am correct it strikes me that 100% reserve also has the potential for banking crises if someone higher up on the pyramid defaults on a loan.

  • Robread, You describe a scenario where someone deposits money in a bank which lends it to a third party, who pays the money to a fourth person, who deposits it in another bank, when lends it on, etc etc. This does not create a systemic risk because if one of the people to whom a bank has lent goes bust, that’s tough for the bank, but it has no implications for anyone else on the chain. This phenomenon occurs under both full reserve and fractional reserve.

    The essential difference between full and fractional is that given an outbreak of irrational exuberance, fractional reserve stokes the fire by producing more money for those wanting to purchase over-priced property or engage in some other unsound activity. Under full reserve, the quantity of money is fixed (or more nearly fixed than under fractional reserve). Thus while the irrational exuberance could still lead to a boom followed by a bust under full reserve, it ought to be less violent than under fractional reserve.

    At least that’s my opinion. Obviously Steve Horwitz doesn't agree.

  • robread

    On the "irrational exuberance" issue – my reading of Steve's article is that in this scenario banks will see a decline in demand to hold their assets (as investors reduce cash balances to make other investments) and in response will hold larger reserves and so reduce loans and the money supply and hence play an anti-inflationary role.

    On the first issue – surely in some circumstances a bad loan under 100% reserve will still cause a banking crisis if it causes the bank that holds the loans to itself default ?

    I'm new to this subject and am trying to get to the essence of the differences between the 2 systems. To me at least its becoming clear that to characterize 100% reserve as totally safe and FRB as inherently inflationary is incorrect. FRB has some clear and big advantages (better use of available capital, diminished value of money commodity) , some theoretical advantages (stabilizing money supply ) that rely on some assumptions on how FRB will calculate their reserves and how fast they can adjust them in reality, and some risks that appear to be accepted as genuine by both sides in the debate (FRBs have the theoretical possibility of destabilizing the economy thru too fast monetary expansion – though FRB advocates would argue that such behavior would not be profit-maximizing in the long-run).

  • I'm sorry, but I'm more aligned with the skepticism of Hayek as L. White pointed out in his article on how Hayek was "not a supporter of laissez-faire banking." It's hard to look at our recent financial crisis and not see irrational behavior by lenders who did not respond to signals that should have caused them to reduce lending. Assets prices "which will determine if the entrepreneurial judgment of the bankers is correct" were often determined by the entrepreneurs themselves (see Lewis' The Big Short) they were mispriced.

    Others have pointed out, and as Smith seems to describe in Scotland in the Wealth of Nations, the guys running the biggest banks have deep flaws and are very prone to irrational decisions. They compete hard for profits, resulting in either creation of differentiated banking products that fewer people can understand (information asymmetries) or don't respond properly to price mechanisms– as Hayek said. Wall Street psychotherapists report CEOs with addictions to drugs, prostitution, their own egos, etc.
    I think Greenspan's recantation of his faith in the market to self-regulate is notable. It's not just that our banks take risks because they feel they have an implicit guarantee, there is a greater problem here.

    What keeps banks in free banking from consolidating to the point where one does not see a monopoly/oligopoly? Banking these days is a lot more than taking deposits and making loans. Companies want risk management, insurance, hedging– all of this is now banking.

    Any readings you could direct me to on the subject of free banking and monopolistic competition would be appreciated. Thanks.

  • coolsvil20

    "for increases in the monetary base to become increases in the supply of money, the banks have to cooperate by lending out their excess reserves. Banking Rule #1 does not say that fractional reserve banks must lend out their excess reserves, only that they cannot lend more than their excess reserves."

    So, if lending out money from excess reserves will increase the monetary base which will result to an increase in supply of money, why not do it? I think that the risk in expanding the monetary base exceeds the risk in holding the excess reserves. Or why not lend out half of the excess reserves and help expand the base slowly? I believe in laissez-faire, get rid of the central bank and expand our monetary base!

  • johanlin

    I just wrote an article about the arguments against our current monetary system, and the criticism surrounding fractional banking with fiat money.

    Feel free to join the debate!

  • Paul Marks

    "If I deposit a thousand Dollar check in my bank…." there is the problem – right at the start.

    A "check" is not a deposit – it is a request to transfer money (not money itself). Only when and IF the money (the notes and coins) is transfered from the bank who issued the check to the bank that recieved it, is any deposit made (after all the check may "bounce") – not till then. And as the notes and coins will no longer be in the first bank (when they are moved to the second bank) the net increase in the money supply is ZERO.

    However, the above is only under an honest system – under this system……

    A "loan" may not be a the transfer of money from real saver to borrower (either directly or via a bank), a borrower may simply have "money" (bank credit – credit bubble stuff) "credited to his acount".

    And there may be many other book keeping tricks including ones that involve checks/cheques.

  • Mohamed

    If you try to get rid of central banking, you'll be a DEAD MAN believe me!!

  • Robert Crim

    I must disagree with the analysis for being static rather than dynamic. Credit expansion in a FRS system occurs because (1) it takes time (though not much time today) to clear the system, enabling banks in a daisy chain to "work the float": in a way that's illegal for you and me (because of embezzlement laws), and (2) because banks in expansion have the ability to create more loans than they extinguish. The ten-to-one expansion posited as an example represents a theoretical maximum, rarely (if ever) obtained, which to the extent it does obtain occurs over time. The harm seen by von Mises and Hayek was that such artificially depresses interest rates on the producer loan market (the inflation is incidental and often is not visible, since it becomes confined to the capital plant). But, the Austrian point is that, per the Fundamental Theorem of Capital, a lowering of interest rates increases the value of all existing capital along all of the input curve (it stretches the DMVPs), and an artificial lowering ARTIFICIALLY inflates capital values. Because such an inflation is system wide, entrepreneurs have no anchor by which they can avoid being fooled into making mal-investments, and eventually there IS a day of reckoning (too complex to go into here), when the system is obliged to contract, sometimes violently if the crisis be sparked by the failure of a big bank in the daisy chain. At that point, a credit contraction occurs, interest rates rise, and the value of capital all along the curve FALLS. That manifests itself in a bear equities market and, ultimately, unemployment when overextended businesses unable to get new loans are forced to close.

    And, in all of this, I haven't talked about consumer inflation (inflation as defined by the Fed) ONCE! Though it does play a role in the process (eventually).

    Is the problem central banking rather than fractional reserve? Central banks do co-ordinate the process, but they don't actually create the money. Banks in daisy chains do, and they do that via a process that would get you or me ten years in the clink were we to try it. Which should tell us right up front where the real problem lies.