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What Bank Intermediation Means

As part of my relentless (some will say obsessive) quest to stamp-out fallacies perpetrated by the 100-percent reserve bunch, I found myself engaged in a discussion with some of them in the comments section of my last post. As the discussion took place some days after that post was published, I hope I may be pardoned for reproducing parts of it, in the hope that doing so might further my overarching objective.

The discussion was prompted by a remark from 100-percenter Paul Marks, who insisted (with his usual emphasis) that "Total borrowing (of all types) must never be greater than total REAL savings of PYSICAL [sic] money. …I repeat that I am NOT making a legal point – I am making a moral and logical one." In reply I wrote as follows:

Paul, what you are saying makes no sense at all. It is the very nature of lending and borrowing of "physical" assets through intermediaries that the value of financial assets or IOUs tends to exceed that of the physical assets involved. I lend a cow to A, an intermediary, in return for A's promise to return the cow to me with interest; A lends the same cow to B, in return for a like promise from B. So: one cow, two promises, no harm, no foul.

I then added,

Just to be clear, Paul, in case the "morality" of intermediated lending should not be sufficiently evident: In the example above, I understand that A is acting as my agent; because I am not in a position to expend resources to discover a worthy borrower to whom I may lend my cow, with reasonable assurance of having it returned with interest, or because I am otherwise unable or unwilling to execute the necessary contracts myself, I allow A to take on these tasks for me, in return for his own commitment to repay my principle with interest.

Where loans of "physical" money are involved, the fungibility of that money allows a bank–which is just a name for an intermediary of money loans–to assemble loans from numerous creditors, and to lend funds so assembled to an equally diverse set of borrowers, all of which serves to reduce, ceteris paribus, the banker's prospects of being unable to meet his various commitments, lowering in turn the credit risk borne by individual bank creditors.

For centuries persons with idle base money balances have found it convenient to relinquish them to bankers as a means for earning interest on such balances with less risk than they would incur by lending them directly, while also (in cases in which deposits are made in exchange for a bank's demandable debt instruments) having access to means of payment often far more convenient than physical (narrow) money itself.

Of course, as with all forms of lending, lending through banks is not risk free. But that hardly makes such lending either unethical or imprudent. Those who, rather than wishing merely to oppose such regulatory interventions as serve to augment artificially the prospects of bank failures and financial crises, plead instead for banning bank-intermediated lending altogether, though they affect to argue as proponents of freedom and morality, in fact seek to arbitrarily limit the scope of freedom of contract, and by doing so make themselves far more deserving of the charge of immorality than the bankers whom they so loftily–and so uncomprehendingly–criticize.

Reacting to my first remark, perhaps without having read the second, Mike Sproul wrote:

Except that if B doesn't pay A, and A doesn't pay you, there is both harm and foul. If the only security for A's IOU is A's possession of B's IOU, then you would insist that B's IOU be signed over to you when A lent the cow to B. Either that, or you would have placed 1 cow's worth of lien on A's other property before accepting A's IOU in the first place. Try it with a house sometime, and see if you can get lenders to carry $200,000 worth of IOU's based only upon a $100,000 house.

To which I observed:

Like I said, all lending is risky. And of course (in the absence of government bailouts) intermediaries don't survive if they continue to make excessively risky or insufficiently secured loans. The tendency, when it comes to banking, for some to hold the industry to be either inherently untenable or immoral or both because banks will occasionally fail is frankly silly. Applied to industry in general, this tendency would have it that we should put an end to all business activity, on the grounds that some people are bound to lose their shirts otherwise!

No one, in any event, is "forced" to transact with a fractional reserve bank. No law, so far as I am aware, has ever prohibited the establishment of 100-percent warehouse alternatives. (Please don't bring up deposit insurance: what I am saying goes for the long history predating both that and TBTF.) No law prevents anyone from keeping cash in a safe or safety deposit box. To the extent that the law has ever had any say regarding bank's [sic] reserve-holding decisions, that say has ever been one commanding banks to maintain some minimum positive reserve ratio–never a "maximum" ratio! And of the few important 100-percent "banks" ever established, almost all have been government sponsored arrangements, usually subsidized or otherwise propped up by laws banning would-be fractional reserve rivals.

I do sympathize with those younger students of economics, and of Austrian economics especially, who, having fallen under the sway of anti-fractional reserve propaganda disseminated by Rothbardians and their fellow travelers, have been tempted to jump on the anti-FRB bandwagon. But for the grown-ups responsible for so tempting them, I confess I have nothing but contempt. The a-priori grounds upon which they condemn FRB are utterly without merit, while a superabundance of empirical evidence flatly contradicts their positions. They are to Austrian economics what the Flat Earth Society is to geology, which is to say (to employ Leland Yeager's expression): an embarrassing excrescence.

I urge readers of who agree with me, and who know some of the misinformed students to whom I refer, to share this exchange with them, in the hope that it may contribute toward their eventual, successful deprogramming. We can, of course, never hope to purge Austrian economics entirely of the 100-percent-reserve bacilli by which it has become infected in recent years. But we can at least hope to build up such a core of well-informed antibodies as may eventually prevent those bacilli from doing any more harm to the main body of Austrian thought than the occasional e-coli does to an otherwise robust digestive tract.