In the previous article we looked at free market banking institutions. We discussed that money is the commodity (historically gold and silver) selected by the market as the preferred medium of exchange, and that gold warehouses serve as an efficient means to store and trade gold. In this article we look at fractional reserve banking, which is the practice of banks lending out their customers deposits in multiples. This appears to be at odds with our discussion in previous articles, so we scrutinize the practice to see if we cannot reconcile the apparent inconsistency.
Savings and lending
Before we discuss fractional reserve banking, it is important to understand the essence of savings and lending. The first myth to dispel is that money is wealth. Money is not wealth; real wealth is tangible physical goods. Your house, your furniture, your car, your golf clubs -- those are real wealth. Money, as the medium of exchange, is a claim on real wealth. Therefore, the act of saving is the expression of an individual’s preference to relinquish his claim on wealth today for a future date. It is very important to understand this. Money is a convenience that arose to facilitate trade. Before money, every trade was an exchange of real wealth (barter). With the introduction of money, every trade is still an exchange of real wealth, just temporally disconnected because the receiver of the money doesn’t complete his side of the trade (receive his goods) until he spends the money he received in exchange for his goods.
This is true of lending as well. Jones borrows $1000 today to purchase goods and services. Tomorrow he repays $1000, but is actually repaying what the money can purchase. He borrows real wealth, and returns real wealth. Therefore, lending entails a transfer of real wealth from lender to borrower. The existence of money tends to obfuscate this insight, but does not change it.
Bank lending
Recall that gold warehouses are storage facilities. An individual depositing money at a warehouse does not relinquish his or her ownership of it, and more importantly, does not relinquish his or her claim on real wealth. The money is still theirs to spend, it is just being safeguarded. This arrangement is a checking account. Alternately, the depositor may instruct the warehouse to lend out their money through a savings account. Here, a depositor relinquishes his or her ownership of the money to the lending institution and thus the would-be borrower. Restated, the depositor relinquishes his or her claim on real wealth in favor of the borrower. In this manner, real wealth is saved, and lent out. The transaction is still a trade of real wealth where money is merely the intermediary.
(The restrictions on savings accounts may actually be quite lax. There is a clear precedent in how mutual funds are structured today.)
Fractional reserve banking
Historically, gold warehouses (or was it goldsmiths?) found that their customers rarely withdrew their deposits; mainly because the receipts to the deposits were as good as the deposits themselves and thus came to be traded in their lieu. Therefore, much of the gold remained in the vaults untouched. Lending this gold at interest, they could make a good profit with repercussions only if more gold was demanded for withdrawal than was currently in the vault. Thus the practice of fractional reserve banking was born. Today, this basic scheme is operate on a large scale by all banks in a government regulated environment. The government establishes a reserve ratio, which sets the fraction of deposits that must be held at the bank. Thus, if the reserve ratio is 0.1, then 10% of all deposits must be held at the bank and 90% are free to be lent out. This has the net effect of allowing 9 times the deposited amount to be lent out. Here is how the process works:
Jones deposits $1,000 at bank A. With a 0.1 reserve ratio, bank A can lend out $900 of that deposit and keep $100 on hand as reserves. Let us say they lend out $900 and it makes its way to Smith – either he borrowed it, or the real borrower used it to pay him. Smith now has $900 that he deposits at another bank, B. Bank B, in turn, keeps $90 as reserve (10% of $900) and lends out $810 to someone else. This $810 is spent and deposited at bank C, which keeps $81 as reserves and lends out $729 to someone else. As this process continues, the total amount lent out by the various banks in the system adds up: $900 + $810 + $729 + …. The sum of this series is $9,000. The total held in reserve also adds up: $100 + $90 + $81 + $72 … = $1,000. Thus $9,000 of lending is supported by $1,000 in reserves. This is why most commentators will state that fractional reserve banking allows the lending of multiples of reserves. Technically, it is not the bank that received the initial deposit that can lend out a multiple, but rather the system as a whole creates it through the process described above.
Having described the mechanism, let us examine it more carefully. When Jones deposits $1,000 in his checking account, bank A issues him a receipt stating that he has $1,000 on deposit. This is a promise to pay $1000 dollars on demand. If bank A lends out $900 of that $1000 then they are no longer capable of honoring their liability to Jones. What they are banking on (excuse the pun), is that Jones will not attempt to withdraw his money before they are paid back on the loan they made. With a single customer, Jones, this is a reasonable risk. However, with hundreds of customers, it becomes far less risky since they can siphon funds between accounts and repay Jones with someone else’s deposit. What they fear then is a run on the bank where a critical mass of customers simultaneously demands withdrawals in excess of total reserves, making them insolvent.
It should be apparent to the reader by now that this is fraud, plain and simple. Some commentators will describe it as counterfeiting, but I think fraud is a more appropriate term as counterfeit bills are not at the root of the fraud. Far more important, however, are the consequences of fractional reserve banking on the economy.
Inflation and the business cycle
If you read my articles on inflation, it should be clear that fractional reserve banking is highly inflationary because it is nothing but an increase in the money supply. This, of course, is accompanied by all the attending ills of inflation, but none more so than the business cycle.
Recall that money is only a claim on real wealth. When Jones deposits his $1000 in his checking account, he does not relinquish this claim; he is merely choosing not to exercise it. When his money is lent out and spent on goods or services, those goods and services are diverted to individuals who would not have otherwise received them. Had Jones instead stuffed his mattress with the cash, he would have maintained his claim on real wealth and not lent out his money. However, placing it in a bank, he has unwittingly been defrauded into relinquishing his claim on real wealth and lending out his money. This is known as forced savings and is vitally important in understanding the business cycle. It is demonstrable that forced savings along with other related factors causes market dislocations that result in booms and busts. The business cycle is not an inherent instability in the free market caused by “animal spirits”. To suggest so betrays a highly superficial and childish understanding of the macro economy and catallactics. The business cycle is, in fact, a direct result of inflation and government intervention as Austrian have carefully detailed beginning with the publication of Von Mises’s masterwork on money and capital, The Theory of Money and Credit. I will explore these ideas more completely in my article on the business cycle. You can read Rothbards introduction here or Gene Callahans explanation here.
Conclusion
It has been shown that savings and lending are voluntary acts on the part of the lender and borrower to trade real wealth now and in the future. Fractional reserve banking undermines this, creating instability in the economy, and resulting in the business cycle. Further, fractional reserve banking should be correctly identified as fraud because it enables the multiplication of money and creates counterfeit claims to the unchanged pool of real wealth. One common argument often put forth by apologists is that the bank, through fractional reserve banking, can pay interest on deposits thus benefiting the depositor. That this argument is actually accepted in debate today is testament to how badly understood the theory of money and banking is. Whatever is gained in nominal interest payments is lost -- and more -- through inflation. The creation of fake receipts does not also coincidentally create real wealth; it only dilutes claims to it. Thus if the depositor had 10% of the money supply before (a claim to 10% of real wealth), he has less than 10% after, thus commanding a smaller claim on real wealth. Even if he has more dollars, those dollars are worth less. Thus, he enjoys a nominal gain, but suffers a real loss.
References
Rothbard on fractional reserve banking.
Rothbards great introduction to money and banking.
Mises on money, by Gary North.
Money, Banking, and the Federal Reserve, complete transcript.
Showing posts with label Banking. Show all posts
Showing posts with label Banking. Show all posts
Monday, September 24, 2007
Tuesday, September 11, 2007
Free Market Banking
In the previous article we looked at money and how it arises in the market. We determined that money is a commodity that is selected by the market as the medium of exchange. Only a commodity with prior value can gain this status, as exemplified by Mises' regression theorem. The commodity that gained wide acceptance was precisely gold, and to a lesser extent silver. Although money is the lifeblood of the market economy, as physical gold it has not realized its full potential -- for that, we need banking.
Recall that money should be portable, divisible, and durable. Gold is all of these, however, for large transactions, it can still prove cumbersome. There is also the added complication of storage. Even though physical gold eliminates many costs of barter exchange, such as time and effort, it cannot eliminate all costs, particularly transaction and storage costs. However, the market has a solution: money warehouses. I use the term warehouses and not banks because free market banking is different from the current fractional reserve system. In order to understand this difference it is important to first look at how warehouses would function in a free market and then consider the differences with the current banking system.
Banking as a convenience
In a free market, money warehouses function as depositories, much like how any storage facility works today. The owner deposits his gold, pays a storage fee, purchases insurance if desired, and receives a receipt certifying the deposit. This receipt entitles him to immediate withdrawal of his gold at a moments notice. Precisely how the receipt at any storage facility today allows one to retrieve their property whenever they desire.
Storage fees and insurance costs are unavoidable no matter how gold is stored. Storing gold anywhere, whether at home, in the backyard, or buried under a tree incurs costs. Sometimes these are indirect (time, effort, lost opportunity) and not recognized as costs, but they still exist. In addition, there is always the risk of theft and insurance is necessary to protect against this. Clearly the price paid for insurance is commensurate with the safety of the storage facility. Due to the benefits of specialization, money warehouses can offer the lowest storage and insurance costs. In fact, there is a huge economic incentive for money warehouses to forward integrate their business to provide storage as well as insurance. This ensures rock-bottom fees, and aligns the incentives of the customer and warehouse: now neither wants the gold stolen; the customer for obvious reasons, and the warehouse because they are on the hook as sellers of the insurance policy.
Warehouses greatly reduce the cost of storing gold, but what about transaction costs? They serve to lower these as well. Suppose Smith and Jones enter a trade where Smith agrees to pay Jones 100 ounces of gold. To fulfill his commitment, Smith must withdraw gold from his warehouse and deliver it to Jones. Jones then deposits it in his own warehouse for safekeeping. This requires time and effort. Alternately, Smith can write Jones a check, which, when cashed, instructs Smiths warehouse to pay Jones 100 ounces of gold, drawn on Smiths account. Most likely Jones will deposit the check at his own warehouse. If they belong to the same warehouse this is a simple bookkeeping entry. If they are customers of different warehouses this can still be cost effective since the two warehouses can aggregate all such trades between their customers and physically settle in the manner most convenient. Economies of scale ensure that the costs borne are lower than individual transactions. Presumably, Smith and Jones prefer low costs and high convenience so they opt to pay the service fee for using their warehouses rather than making a direct exchange.
We see that money warehouses play an important role in making gold more cost effective as the medium of exchange. Ultimately, however, they are nothing more than a convenience. They merely serve to lower the costs and increase the convenience of trading physical gold. This is not to say that lending institutions paying interest on gold deposits will not exist in a free market. They absolutely will. However, they should be recognized as distinct from money warehouses. This will be discussed more clearly in the next article on fractional reserve banking.
Paper money
While the system above is already a vast improvement over direct exchange, there is still one further improvement we can envision. If the receipts issued by a gold warehouse are redeemable by the bearer of the receipt, then individuals can simply trade receipts as if trading actual gold. These paper receipts, or bank notes, eliminate transaction costs, but introduces a new risk: counterfeiting -- the notes may be fake. However, again due to economies of scale, well known and trusted warehouses can issues hard to counterfeit notes, similar to federal reserve notes (dollars) today. This situation presents the same risk as using dollars today, so it is highly conceivable that it can evolve and be sustained in a free market. In fact, this phenomenon has been observed repeatedly throughout history, but unlike the system today, there will be no monopoly on the issuance of bank notes.
(An interesting corollary is the origin of the word "dollar", which can be traced to thalers, silver money coined by the Count von Schlick. These private coins gained wide reputations for their integrity. Most people recognizing the seal were willing to trust the integrity of the coin, much as anyone recognizing the seal on federal reserve notes today is willing to trust the integrity of the note. Why should it be any different with private bank notes?)
Conclusion
Banking in a free market takes the shape of money warehouses which serve as a secure place to store gold and an efficient way to trade it. Since warehouses issue receipts that are redeemable at a moments notice, they must keep all the gold on the premises at all times. They are not the owners, they are merely the caretakers. To do otherwise is fraud or theft. This will be discussed more clearly in the article on fractional reserve banking. The best known example of free market banking has been the Banca della Piazza del Rialto, which grew to become the center of Venetian commerce. Another example is the Bank of Hamburg, which was eventually compromised when Napolean took control of it.
In the article on fractional reserve banking we will also look at the structure of free market lending institutions. It should be clear, however, that gold warehouses, as described above, are not lending institutions. They are merely storage facilities to lower the costs of transacting in gold.
As for whether bank notes will be widespread, it is very likely so, but it will depend on the relative costs. Only the market can decide. As individuals evaluate alternatives and make choices, they will decide if they prefer checking accounts or bank notes. Each individual, weighing his preferences against the costs and risks and deciding on the former, the latter, or a hybrid of the two, will have the effect of the market selecting the most appropriate solution. When Austrians talk about to the market "selecting" a good or services, it is precisely this phenomenon that they are referring to. It derives from profit-loss accounting, an extremely important concept in understanding how markets function.
References
Rothbard's must read introduction to money and banking.
Recall that money should be portable, divisible, and durable. Gold is all of these, however, for large transactions, it can still prove cumbersome. There is also the added complication of storage. Even though physical gold eliminates many costs of barter exchange, such as time and effort, it cannot eliminate all costs, particularly transaction and storage costs. However, the market has a solution: money warehouses. I use the term warehouses and not banks because free market banking is different from the current fractional reserve system. In order to understand this difference it is important to first look at how warehouses would function in a free market and then consider the differences with the current banking system.
Banking as a convenience
In a free market, money warehouses function as depositories, much like how any storage facility works today. The owner deposits his gold, pays a storage fee, purchases insurance if desired, and receives a receipt certifying the deposit. This receipt entitles him to immediate withdrawal of his gold at a moments notice. Precisely how the receipt at any storage facility today allows one to retrieve their property whenever they desire.
Storage fees and insurance costs are unavoidable no matter how gold is stored. Storing gold anywhere, whether at home, in the backyard, or buried under a tree incurs costs. Sometimes these are indirect (time, effort, lost opportunity) and not recognized as costs, but they still exist. In addition, there is always the risk of theft and insurance is necessary to protect against this. Clearly the price paid for insurance is commensurate with the safety of the storage facility. Due to the benefits of specialization, money warehouses can offer the lowest storage and insurance costs. In fact, there is a huge economic incentive for money warehouses to forward integrate their business to provide storage as well as insurance. This ensures rock-bottom fees, and aligns the incentives of the customer and warehouse: now neither wants the gold stolen; the customer for obvious reasons, and the warehouse because they are on the hook as sellers of the insurance policy.
Warehouses greatly reduce the cost of storing gold, but what about transaction costs? They serve to lower these as well. Suppose Smith and Jones enter a trade where Smith agrees to pay Jones 100 ounces of gold. To fulfill his commitment, Smith must withdraw gold from his warehouse and deliver it to Jones. Jones then deposits it in his own warehouse for safekeeping. This requires time and effort. Alternately, Smith can write Jones a check, which, when cashed, instructs Smiths warehouse to pay Jones 100 ounces of gold, drawn on Smiths account. Most likely Jones will deposit the check at his own warehouse. If they belong to the same warehouse this is a simple bookkeeping entry. If they are customers of different warehouses this can still be cost effective since the two warehouses can aggregate all such trades between their customers and physically settle in the manner most convenient. Economies of scale ensure that the costs borne are lower than individual transactions. Presumably, Smith and Jones prefer low costs and high convenience so they opt to pay the service fee for using their warehouses rather than making a direct exchange.
We see that money warehouses play an important role in making gold more cost effective as the medium of exchange. Ultimately, however, they are nothing more than a convenience. They merely serve to lower the costs and increase the convenience of trading physical gold. This is not to say that lending institutions paying interest on gold deposits will not exist in a free market. They absolutely will. However, they should be recognized as distinct from money warehouses. This will be discussed more clearly in the next article on fractional reserve banking.
Paper money
While the system above is already a vast improvement over direct exchange, there is still one further improvement we can envision. If the receipts issued by a gold warehouse are redeemable by the bearer of the receipt, then individuals can simply trade receipts as if trading actual gold. These paper receipts, or bank notes, eliminate transaction costs, but introduces a new risk: counterfeiting -- the notes may be fake. However, again due to economies of scale, well known and trusted warehouses can issues hard to counterfeit notes, similar to federal reserve notes (dollars) today. This situation presents the same risk as using dollars today, so it is highly conceivable that it can evolve and be sustained in a free market. In fact, this phenomenon has been observed repeatedly throughout history, but unlike the system today, there will be no monopoly on the issuance of bank notes.
(An interesting corollary is the origin of the word "dollar", which can be traced to thalers, silver money coined by the Count von Schlick. These private coins gained wide reputations for their integrity. Most people recognizing the seal were willing to trust the integrity of the coin, much as anyone recognizing the seal on federal reserve notes today is willing to trust the integrity of the note. Why should it be any different with private bank notes?)
Conclusion
Banking in a free market takes the shape of money warehouses which serve as a secure place to store gold and an efficient way to trade it. Since warehouses issue receipts that are redeemable at a moments notice, they must keep all the gold on the premises at all times. They are not the owners, they are merely the caretakers. To do otherwise is fraud or theft. This will be discussed more clearly in the article on fractional reserve banking. The best known example of free market banking has been the Banca della Piazza del Rialto, which grew to become the center of Venetian commerce. Another example is the Bank of Hamburg, which was eventually compromised when Napolean took control of it.
In the article on fractional reserve banking we will also look at the structure of free market lending institutions. It should be clear, however, that gold warehouses, as described above, are not lending institutions. They are merely storage facilities to lower the costs of transacting in gold.
As for whether bank notes will be widespread, it is very likely so, but it will depend on the relative costs. Only the market can decide. As individuals evaluate alternatives and make choices, they will decide if they prefer checking accounts or bank notes. Each individual, weighing his preferences against the costs and risks and deciding on the former, the latter, or a hybrid of the two, will have the effect of the market selecting the most appropriate solution. When Austrians talk about to the market "selecting" a good or services, it is precisely this phenomenon that they are referring to. It derives from profit-loss accounting, an extremely important concept in understanding how markets function.
References
Rothbard's must read introduction to money and banking.
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