Fractional Reserve Banking Reconsidered

Curses, Randall, for beating me to this topic by a fraction of a second. (Get it? Fraction/Fractional? Haw, haw.)

One highlight of Mises University was the faculty panel on Macroeconomics given by Professors Hülsmann, Block, Hoppe, Long, Salerno, and Garrison. Somehow, they got on the topic of suitcase nukes and Godzilla pills (a substance that turns its user into something approximating Godzilla). (Don't ask.) Walter Block, being the resident suitcase nuke and Godzilla pill expert, eagerly fielded this topic. When everyone else's patience began to wear thin, Hülsmann proclaimed: "Let's move on to other extremist things." A good laugh was had by all.

The thing that surprised me, though, is that as much as Block was willing to defend the private ownership of nuclear weapons under certain situations--after all, this is the man who wrote Defending the Undefendable--, he was completely unwilling to even entertain the notion of fractional reserve banking in a truly free market.

Why? As Randall already mentioned, so long as all the parties involved are informed, there is no issue of fraud. Certainly, fractional reserve notes contain an element of risk, but then so do many other tradable objects of value, such as stocks and bonds. Why all the fuss over not-fully backed currency? Would these same Austrians who object to fractional reserve banking also object to the trading of penny stocks on grounds of fraud?

I argued this point with Professor Block, but did not receive a satisfying answer. During his lecture on road privatization, Block emphasized that he is an economist, not a road entrepreneur, and therefore he cannot know exactly what innovations road entrepreneurs might use to market their product to consumers, nor can he know, ex ante, what a market in roads will look like. He then gave some suggestions, based somewhat on historical precedent, but again emphasized that a road market in the future will most likely look very different from a road market in the past.

Yet, during his lecture on the gold standard, while he did say that there was no assurance gold would be the preferred medium of exchange, he seemed pretty certain that gold would be of similar use as in the past, and completely ignored the possibility that consumers might find fractional reserve currencies preferable to fully-backed currencies. I certainly would. I trust my bank not to abscond with my hard earned gold; why not further trust them to maintain a stable reserve ratio? And if they drop that ratio too low, I'll just switch banks.

Block suggested two exceptions to contract in order to counter my anti-fraud argument. What if I Smith agrees to purchase a square-circle from Jones? Should the court enforce this contract? To which I responded (from memory, so this is paraphrase): I'd have to see what the contract says. If the contract says something like "I, Smith, agree to purchase a square-circle from Jones, knowing full well that no such thing exists and am merely doing this because I enjoy giving Jones my money for the novelty of purchasing non-existent items," then yes, the court should enforce the contract. (This ignores certain elements of contract law which I will not delve into here.) But if the contract did not make clear that Smith knew that what he was getting did not and could not exist, then no, I would not enforce the contract. But what does this have to do with fractional reserve banking? Is Block's claim that fractional reserves don't exist, in the same sense that square-circles don't exist? Clearly that is not the case. They exist; they just entail a risk that should a bank run occur, they become worthless.

Block's second argument against contract was whether a murder-for-hire contract should be enforced. I objected, on the grounds that a murder-for-hire contract involves third parties who did not agree to the terms of the contract and would strongly object if given the opportunity to do so. So long as all those who use and accept fractional reserve currency know the risk, there is no third party issue.

This was a common objection I used last week: How can we know, ex ante, what a truly free market will look like? We can use economic arguments to explain why a free market would be preferable to socialism and lead to better results, but we can't say for certain what those results will be. What's the point of developing a complex, detailed, libertarian legal theory to resolve specific legal arguments if judges under a free market for law decide cases based on the only factors that matter in a free market: supply and demand? I.e., consumer preferences, competition, costs, benefits, and all that other fun stuff. Or are we just going to clone Rothbard and make sure all judges use identical libertarian jurisprudence?

This relates to a previous post of mine from two weeks ago, in which I wrote:

I think there is a strong connection between subjective value in economics and subjective value in ethics. If we cannot say, a priori, that all people value the same economic goods with the same ordinal rankings, how can we say, a priori, that all people value the same ethical goods with the same ordinal rankings?

The market for law is exactly where this issue comes into play. It seems that all too many free-market advocates, especially Austrian economists, are subjectivists when it comes to analyzing market prices and consumer preferences for cars, food, healthcare, and education, but objectivists when it comes to market prices and consumer preferences for law. Why is it that we cannot know anything about whether Nike is objectively more or less valuable than Reebok for the consumer of shoes, yet we can be so certain that purely libertarian legal code is objectively preferable to all other legal codes for every consumer of law?

I didn't want to turn this into another debate over subjective ethics, but I hope everyone can see why these two issues are closely related.

Randall and I met Jonathan Dingel at Mises U., who runs the tongue-in-cheek-titled blog Exploit the Worker. Jonathan knows his Nietzsche, attended Cato University the week prior, and took more notes than arguably anyone else in attendance. He also has a nice post on fractional reserve banking, some excerpts from David Friedman's argument in favor of it, and some historical evidence in support of it. Friedman offers two reasons why a fractional reserve banking would be preferable to a fully-backed system. First, fewer resources are wasted as reserves under a fractional reserve system. These resources can be put to use elsewhere in the economy rather than sitting in a vault all the time. Second, fractional reserve banking provides its own funding. Since gold or commodity deposits are essentially an interest-free loan to a bank from its customers, banks will be forced to offer interest to their customers if they want to stay competitive. Under a fully-backed commodity system, banks are nothing more than warehouses, and no property owner is going to waste good land space without something in return. Professor Salerno made this point during the lecture: he predicted that fractional reserve banks would not only lose out to fully-backed banks, but also that people would tend to carry actual commodities in their pockets rather than bank notes because of the cost of depositing.

Is that a fully-backed commodity in your pocket or are you just happy to see me?

Walter Block and his famous money bin
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I'm not objecting "that

I'm not objecting "that polycentric law would result in communists tyrannizing libertarians". I'm saying, without metalaw it would collapse into immediate chaos and civil war.

But the moment that states

But the moment that states arise, a polycentric legal order is no more (by definition).

Therein lay the problem Patri spoke to, in essence. First, how do you get there, and Second, how do you *stay* there.

It may very well be that staying in the libertarian utopia requires unlibertarian means due to the unlibertarian substrate upon which the utopia is built...

I suppose one could posit that getting to a libertarian utopian framework would presuppose a libertarian substrate, but that (a) doesn't help us and (b) undermines arguments that aspects of the framework would generate the free society, since you're positing the free society as a prerequisite.

I’m not objecting “that

I’m not objecting “that polycentric law would result in communists tyrannizing libertarians". I’m saying, without metalaw it would collapse into immediate chaos and civil war.

Why? There is no metalaw for nation-states, yet nation-states are not in a perpetual state of war, and between Western states, war is rare.

What do you mean by a

What do you mean by a "metalaw"?

I imagine it is something akin to my "culture of liberty" but perhaps more specific?

When Europe was riven into

When Europe was riven into tens of thousands of microstates, Europe was indeed in a perpetual state of war.

Granted, a war between one town and another isn't much compared to WWI, II, etc.

But I think that with fewer states comes fewer state conflicts, though raising the stakes/costs of those conflicts when they *do* occur.

Which is why I do not look forward to a day of effective zillions of microstates.

Therein lay the problem

Therein lay the problem Patri spoke to, in essence. First, how do you get there, and Second, how do you stay there.

You stay there by convincing people of the positive-sum worldview of polycentric law.

It may very well be that staying in the libertarian utopia requires unlibertarian means due to the unlibertarian substrate upon which the utopia is built…

Huh?

Which is why I do not look

Which is why I do not look forward to a day of effective zillions of microstates.

Aren't you the guy who took credit for "culture of liberty" above? The ideas that are prevalent today are very different from when Europe was a bunch of microstates.

I say, though, that with the

I say, though, that with the rise of industrialism, humanity has means of production well in excess of population growth, and can increase production of goods through non-population means.

Thus the traditional reasons for aggressive war (gaining land and people, which was essentially gaining productive resources and a captive labor force) are, for the first time in human history, not nearly as potent as they used to be (ala Julian's point). That is the sole reason why Europeans at the end of the 19th century and beginning of the 20th let their Empires go- there wasn't much point to keeping them, cost-benefit wise. You could trade and get the same benefit, and build new factories instead of conscripting new masses of labor.

Granted, this isn't an argument against state violence against the people within its own territorial bounds, nor will it rule out territorial grabs for ideological reasons (bring more people into the fold for their own good; humanitarian intervention & forced integration into a state polity has 'good personal consequences' and so its justified/moral), but rather that history may not be as much of a guide here as I have maintained, which of course is indeed cause for optimism.

When every man is a state,

When every man is a state, every man is subject to the corruption that statism brings. I'd rather that there be no states at all, rather than have the ability for each person to declare absolute physical autonomy/autarky. That is the unpleasant scenario sketched by too many technoanarchists- a dystopian society where people secretly arrange for killing other people they disagree with (and think this is a good development!), extreme, pathological individualism (i.e. extreme antisocial behavior) elevated to an ultimate goal, etc etc etc.

Fortunately, such dystopian thinking is not even remotely near the mainstream of even anarchist thinking. But its worth noting that this atavistic desire to destroy ones enemies (literally) still lurks and undermining the norms or institutions that help keep those desires in check is bad.

My point is that a culture of liberty has some presuppositions, one of which is ruling out violence to solve social/interpersonal conflicts in civil society. This would rule out microstates (a state has the right to use deadly force against The Other, or else its not a state, by definition). I rule out the armadillo dystopian future as being antithetical to a true culture of liberty.

Micha, I was at Mises U.

Micha,

I was at Mises U. last year (2nd Summer) and this same topic was discussed, except Block wasn't at that session. However, Roger Garrison was, and he (being perhaps of a more Hayekian strain of the Austrian breed) echoed your sentiments. He felt that 100% reserve banking was the safest alternative, but that a free market would and should allow for fractional reserve banking -- as long as everyone knew that it was so -- in order to create better capital formation for investment purposes. Garrison felt 100% reserves might be too restrictive for capital formation to occur consistently over time and that Rothbard, et al had not adequately addressed this issue. (I am trying to reconstruct this from memory, so any false attributions are my own fault.)

It seems that a free-market would create a two-tiered financial structure with 100% reserve banking serving the daily needs of most people, but with fractional reserve banking serving in the role of purveyors of investable capital or some type of mutual fund. In fact, I want to say this was Hulsmann's reply: 100% reserve banks functioning as day-to-day capital preservers and mutual-fund-like fractional banks acting as capital forming enterprises.

Fractional reserve banking

Fractional reserve banking requires Govt. to monitor loan quality of the member banks apart from the reserve ratio. Also, it should be left to the bank that issues currencies and settles cheques,to determine the reserve ratio. Thus, free market in currencies is required. See my blog for more on this.

The market for law is

The market for law is exactly where this issue comes into play. It seems that all too many free-market advocates, especially Austrian economists, are subjectivists when it comes to analyzing market prices and consumer preferences for cars, food, healthcare, and education, but objectivists when it comes to market prices and consumer preferences for law. Why is it that we cannot know anything about whether Nike is objectively more or less valuable than Reebok for the consumer of shoes, yet we can be so certain that purely libertarian legal code is objectively preferable to all other legal codes for every consumer of law?

In order for to have subjectivism we need to accept concept of an individual. With individual there is no subjectivity. Thus, in order for to say that you and I can have differing views on this matter, I need to accept you and I as a separate individuals, each capable of independent thought and action.

Thus, subjectivism requires objectivity as far as individual rights are considered. Therefore, libertarians are right in believing that libertarian legal code is objectively prefereable to all other legal codes because it is based on concept of individual rights.

Ashish, fractional banking

Ashish, fractional banking requires no such thing.

(1) Caveat Emptor. You can only get away with fraud for so long before you pay the price in terms of reputation and the high premiums of dishonesty (higher risk, higher payoff required). Too many bad loans = bank is dissolved due to people taking their money out (the dreaded bank run). Problem solved.

(2) Competition. Banks not in forced collusion with each other (ala the Federal Reserve system) are going to try and steal each others' business. That means it is in their interests to know the business liabilities of their competitors and publicize them as much as possible. It is also in their interest to minimize their exposure to the same tactic. In the long run, the honest banks will win out (honest in terms of their choice of good business practice and not lying to cover up bad business practices as a defense against competitors' aggressive muckraking).

(3) Assuming arguendo that 3rd-party monitoring of fractional reserves banks is required, it does not follow that the state must do so. It only follows that a 3rd party must, which can be a private association as much as a state regulator.

[...]yet we can be so

[...]yet we can be so certain that purely libertarian legal code is objectively preferable to all other legal codes for every consumer of law?

Pure competing law (with no overarching metalaw) wouldn't work. Your communist law provider would try to tax libertarian subscribers, and the whole thing would degenerate into a gunfight.

Any system of competing law that requires consent (via choice of law), is functionally equivalent to pure libertarian law. The whole point of communism, coercive greenism, theocracy, etc is that they aren't optional.

Pure competing law (with no

Pure competing law (with no overarching metalaw) wouldn’t work. Your communist law provider would try to tax libertarian subscribers, and the whole thing would degenerate into a gunfight.

Why doesn't the same thing happen today? Why don't the communists tyrannize the libertarians?

Fractional reserve bank

Fractional reserve bank accounts are investment portfolios with the option to cash out. Fractional reserve cash is a trade of freebie cash-backing and provision in exchange for absorbing investment-risk.

While they're both more complex than they appear on the surface, there's no valid reason to make them illegal.

Thus, any formulation has to

Thus, any formulation has to address how states will not re-rise from the A-C state should enough people demand it. It is not enough to say that it would be ‘unprofitable’, because many people engage in statism for statism’s sake, and because resources can be had by theft, etc…

I have not seen the claim made that states would never arise from a polycentric legal system, but rather that it would be difficult, because the establishment of a state in a system in which security was a private good would be difficult. Yet, just as public goods are provided in many ways today, it could still happen.

Jonathan: well duh, they do.

Jonathan: well duh, they do. Cold war and all that? They lost, luckily.

IMO states originally rose

IMO states originally rose because early agriculture was so vastly un-productive. Peasants can't afford the time, effort or materials to defend themselves, but a predator stealing just a little from thousands can collect enough to run an army.

Modern productivity is what will anchor anarchy from degenerating into states.

Jonathan: well duh, they do.

Jonathan: well duh, they do. Cold war and all that? They lost, luckily.

I submit that they still do in the US and Great Britain, both of which have a monopolistic legal system. In fact, they going around taking 40%-50% of our property, telling us what kinds of medicine we can take, how to raise our kids, etc.

So the objection that polycentric law would result in communists tyrannizing libertarians is neither here nor there. The question is which system would be better for nearly everyone involved, including libertarians.

Patri- That gets at a

Patri-

That gets at a concern of mine stemming from history- when I hear some advocates of the anarchist future saying how it is inevitable because of X technology or Y system (ala David Friedman's TMOF style of polycentric law) that states will become meaningless and fade away, I have to wonder "how is it that they came about in the first place?"

States are not exogenous to society, they come from society. States also moved beyond the naked justification for power (I have it, so do as I say) to more and more esoteric justifications, such that the people demand the state more and more. To me, its not any function of a particular system or set of laws that is going to support the state, but rather the demand of the people themselves for the state.

Thus, any formulation has to address how states will not re-rise from the A-C state should enough people demand it. It is not enough to say that it would be 'unprofitable', because many people engage in statism for statism's sake, and because resources can be had by theft, etc...

Which means that it boils down to changing hearts, minds, and cultures if you want to banish the state, rather than coming up with any specific framework, though of course frame building has use outside of long-term considerations.

yet we can be so certain

yet we can be so certain that purely libertarian legal code is objectively preferable to all other legal codes for every consumer of law?

I completely agree with this, but you can make a separate and stronger point. Which is that there is no purely libertarian legal code. Libertarianism is a belief in rights. Unfortunately, the path from rights to legal rules is a murky and wandering one, beset with countless difficulties. They can squawk about rights all they want, but coming up with laws to enforce those rights is a tricky matter, and it requires things like weighing and comparing wrongs to trade them off against each other.

Make 'em read _Law's Order_ to understand just how complicated it is to design a good set of laws, even if you know just what rights you want to enforce. The same problem of unintended consequences that we use to jab at government laws is true of all legal systems.

Hi Micha, I think I'm with

Hi Micha,

I think I'm with the professor on this one. Though I'm also with you, doh! :-)

If I'm charging 1 oz of gold for my services, for one hour's windsurfing instruction, and you offer me a 1 oz gold certificate in payment, from the Ghertner Industries Corp. Bank (GICB), then to me this is a contract that you currently have one real ounce of gold in the vaults of GICB, and that the ownership of this will pass to me if you exchange the note, especially if the note says something like this, and only this:

I, the Chairman of GICB, promise to pay the bearer 1 oz of gold on demand

If I accept your note, the contract statement above implies that I can get this ounce of gold any time I like, even if every other depositer in GICB turns up ten minutes before me and clears out the rest of the vault, except for that single 1 oz gold coin lying there right at the back, presumably bearing the stamp of Uncle Murray's bow tie and glasses upon it, to make it official. All I have to do is exchange the note you gave me, at the bank counter, and that l'il ol' sucker is mine. I am up in the game by 1 oz of gold, no matter what.

However, if the note on the contract is amended, as you did with the square-circle contract, then that would be acceptable too, eg:

I, the Chairman of GICB, promise to try to pay the bearer 1 oz of gold on demand, however the bearer must realise that we operate a fractional reserve at GICB, of 1 to 9, on this series of "Purple" GICB bank notes

Yes, this contract is still acceptable, because it is not hiding anything, but my policy at my windsurfing school would be to accept paper notes only at a premium, dependent upon the fractional reserve rate, and the bank in question, eg:

1 to 1 => Multiply price by 1.00
1 to 5 => Multiply price by 2.00
1 to 9 => Multiply price by 3.00
1 to 25 => Multiply price by 99.99

McElroy's Rock Solid Vaults => 1.01
Ghertner Industries Corp. Bank => 1.1
Duncan's Lucky Dip Emporium => 9.99

So my price to you, for one hour's windsurfing instruction, with your GICB purple paper notes, take it or leave it, would be:

1 oz * 3.00 * 1.1 => 3.3 oz

If you had some McElroy Rock Solid "One-to-One" notes, with a small margin added on for possible note counterfeiting:

1 oz * 1.00 * 1.01 => 1.01 oz

Though obviously, those ol' Duncan 1-to-25 Lucky Dippers, would face a rather stiff premium:

1 oz * 9.99 * 99.99 => 998.90 oz

And then of course, you could offer me a 1 oz gold coin, minted this year by Rothbard Inc. Mints, exchangeable at any time after Jan 1st 2005 for a newly minted replacement, and covered with a Rothbard Inc. Industries one atom thick lattice of diamond, to avoid any wear and tear.

I don't know how the market would go, but I would guess that the McElroy Rock Solids and the Rothbard Mints would quickly come to dominate the market. I would also guess that 'Duncan's Lucky Dip Emporium' Bank would quickly go out of business. How GICB would do with their purple one-to-niners, I'll leave to the market to decide, but the contract on the notes must be unambiguous.

Rgds,
AndyD

There is no question that

There is no question that people need to understand fractional reserve banking more than they do now in our current society.
That said, I think that if people were aware of what fractional reserve banking is then a series of time deposits (clearly defined in the initial contract with the bank) could act for as a demand deposit, getting rid of most of the money creation problem.

Try looking at this problem

Try looking at this problem from the point of view of deflation as being the norm. Supposing you had year in year out GDP growth of 8% with deflation hovering around 6%. Why go to the bank in the first place? For term loans or for extra security of your property. You would only take out demand deposits if you were worried about keeping the Gold safe at home. And the bank would ask for a fee for this service. There would still be a market and a yield curve but it would be clipped off at the bottom end. If this system had always existed it would seem fraudulent for them to loan out the Gold that they were having you pay a fee on since you don't really need the banks and can have your savings grow without them.

Block seems to want to minimize utilitarian or consequentialist arguments in his thinking. Which is probably why you didn't get a satisfactory answer from him. But the real argument against Gold with fractional reserve is that it is not a good monetary system. It has bad consequences and unnecessary recessions. Maybe its better than the current setup or maybe it isn't but if a non-fractional reserve Gold standard could be introduced AFTER we had gotten used to constant deflation than it ought to be a better system than anything yet tried.

the whole problem with

the whole problem with fractional reserve banking is about where the "new money" finally ends up. Hoopla aside, it works like a secondary share offering. New shares of the American economy, new greenbacks, are issued by a small number of people, the bank owners, which dilute the value of other shares in terms of actual goods and services. To rephrase, instead of new stock being issued, and the value of the stock in the market for dollars decreasing, new dollars are issued and the value of a dollar in the goods and services market decreases. But, like any secondary share offering, the percentage of the total shares owned always ends up higher for those who offered the new stock, and lower for everyone else. So with fractional reserve systems (throughout history I'd say) the percentage of available wealth held by the fractional reserve bankers is always increasing.

Here are two things that might help.
1) Depositors in a bank make a contract to not withdraw all of the deposit until a period of time has elapsed, during which the bank could loan out the money without the risk of a bank run. The depositor and the bank could work out the contract over who gets what share of the interest payment.

2) legislate that banks must destroy a dollar for every dollar they create. So if the lend out 1000 "new dollars" and make $100 in interest profit, they would have to destroy the origional 1000 "new dollars" and could keep the interest payment, or some percentage as agreed upon by the depositors and the bank.

My whole thing is that I'd like to spend printing press money and I can't. You can't call a society just if the vast majority of people have to work and earn money while a small elite can spend it out of thin air.

A little side-note: A pure

A little side-note: A pure Gold Standard does _not_ stop the money multiplication in banks, it just makes it harder. Consider everyone using real Goldcoins. They go to the bank, so the bank has heaps of coins. Now if person A has an account at the same bank than B, A can pay B by simply moving money from A's account to B's. No new securities/bills are created. The bank could still lend out a good chunk of its gold coins without getting in trouble (provided there is no bank run).

In order to really stop self-multiplying money, all lending by banks must be prohibited. BTW, if there was a Gold Standard, there would be a huge incentive for banks to merge, since the bigger, the more extra coins for lending. Also, subsidiaries would get fewer and bigger. People would have to drive far to reach their branch.

Greetings, Jonas