Fractional Reserve Hat Checking

From Howard S. Katz, in The Paper Aristocracy, quoted and cited in The 100% Gold Standard: Economics of a Pure Money Commodity , by Mark Skousen --

Assume that all men's hats were the same, and in a given hotel there were continuous functions so that day in and day out there were always hats deposited with the hat check girl. (The hat check girl issued little tickets which served as receipts so that the men could claim their hats when they wanted them.) Suppose then, that the hat check girl noticed that it was very rare for a demand to come in for more than 50% of the hats at one time without this being offset by a new deposit of hats from new customers. Suppose further that an 'enterprising' hat check girl decided to sell 25% of the hats and pocket the money or -- what amounts to the same thing -- issue tickets for hats which don't exist and exchange those tickets for money. Such an event would clearly be fraudulent. The customers, who have a right to their hats, are being deceived. If the girl maintained that she was doing nothing wrong because the hats were her reserves and she maintained enough 'reserves' to meet the normal demand for hats, this argument would not be valid. It is not valid with regard to bankers either.

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Presumably all this argument

Presumably all this argument is supposed to defend a gold standard rather than fiat currency.

I'm not sure why this has anything to do with the gold standard, as you and others have mentioned. Fractional reserve banking is perfectly compatible with a gold-backed currency or a fiat currency. Under either scheme, checkable deposits are backed with currency. Only the central bank has to have gold.

As for why gold, I have no idea either.

I'm with eddie: why do

I'm with eddie: why do otherwise very sensible libertarian economists suddenly forget all about market forces when the conversation turns to banking systems?

Scott, _It cannot, however,

Scott,

_It cannot, however, manufacture more gold._

Well, technically, if you bombard a platinum atom with a hydrogen nucleus and add enough energy (lots), you could manufacture more gold. It's not very cost-effective, though.

Point taken, though. Of course, this shows only that scarce things are more valuable. Still, I don't see what the fetish is with gold. Why not a moon rock standard? Or a giant panda standard? Or a we've-got-a-lot-of-guns-trust-us standard?

Let's slow down here. Don

Let's slow down here. Don quoted a paragraph, neither approvingly or disapprovingly. I think it's a bit hasty to infer he has a problem with fractional reserve banking. Maybe he just wanted our thoughts on something he'd read.

It's hard to say, as Don moves in mysterious ways.

Joe's question is beyond my competence. But one thing I would point out is that the government can print more paper money. It cannot, however, manufacture more gold.

First, let me say that I'm a

First, let me say that I'm a moral theorist and not an economist, so I can't really comment on the desirability of fractional reserve banking. As far as the _moral_ argument goes, though, it's really hard to see how the system could possibly be immoral as long as practices are fully disclosed. It's particularly hard for me to see how it is that a _libertarian_ finds such a system to be immoral. Wouldn't pretty much any business arrangement be perfectly moral as long as all the parties involved consent to the arrangement?

If you really have a deep attachment to your particular bits of currency, then it's really not all that hard to find a bank that will hold on to it for you. They're called safety deposit boxes, and banks will rent them to you. If you're looking to earn interest, though, it's hard to see why a bank would give you that if they can't use your money to make some of their own.

I do have an economics related question, though. Presumably all this argument is supposed to defend a gold standard rather than fiat currency. Here I don't see how the analogy is supposed to work. Certainly it's true that I'd mostly rather have a hat than a claim for a hat. Hats are, after all, pretty useful things. It's not at all clear, though, why I'd prefer having gold to paper (unless I make stereo cables or something). Gold is heavy and inconvenient to carry in large quantities, and as Brandon points out, it's more useful for other things.

Indeed, I find this reverence for gold to be pretty mysterious. Outside of its industrial uses, it's really valuable only because lots of people have decided that it should be valuable. It seems to me, though, that we could use pretty much anything, though. Gold just happens to be the thing that was, historically, deemed to be valuable (aren't we lucky that no one decided to mint uranium coins). As long as everyone thinks that paper currency has value, it does. But the same thing is true of gold; it has value (outside market price for industrial uses) only to the extent that people think it does.

I suppose, then, that I'm confused as to why a gold reserve is such a big deal. If things go badly wrong enough that paper currency is worthless, it's not at all clear that I'd really be a lot better off with a bunch of gold under my bed. Whence the confidence that gold would be any more valuable than dollars?

I really can't see how

I really can't see how fractional reserve banking is fraudulent if everyone knows what is happening. That is generally the case in fractional reserve banking - it is understood as a part of your agreement with the bank that your money won't stay there, hence their actions are not fraudulent in the slightest. If the hat girl made it clear that she would be selling some hats and that what men were getting back was only a claim on one of the available hats, then what she would be doing would not be fraudulent at all.

This is one of the few places where I think the Austrian school goes too far confusing the bad with the unethical. Just because something should be undesirable does not mean it is wrong or evil.

The obvious flaws with this

The obvious flaws with this argument have already been pointed out so here's my question: how the hell would banking work without fractional reserves? If banks can't earn the money to cover their operating costs by lending out deposited money and charging interest, how do they stay in business? Wouldn't they have to charge their depositors a service fee, either directly or (as was done in ancient civilzations) by making banks part of the government and paying for them out of taxes? Given the choice between assuming the small risk of a bank run and having to pay a substantial fee out of my own pocket, I know which option I'd pick.

To complete the hat example,

To complete the hat example, suppose the people who purchased the hats sold by the girl also come to the hotel and deposit them with the hat check girl. You get the hat multiplier.

Here is another post on

Here is another post on fractional reserve banking. It addresses and links to various arguments for and against fractional reserve banking. After more reading on this subject, my feeling is that the problem lies more in the fiat currency than with the fractional reserve banking as such. If notes issued by competing banks clearly state the reserve system (fractional or full reserve) that is used by the issuing banks then there is no fraud involved. Also, when there is no compulsion on anybody to accept notes issued by the state-sponsored central banks (that is there is no fiat-money) then seller can decide if and how much premium to charge on the bank notes offered by the buyer.

I think of (fully-disclosed)

I think of (fully-disclosed) fractional reserve banking as a way of allowing consumers to have what I call "virtual cash holdings." That is, maybe I want to have $5,000 in cash equivalents at all times in case of emergency, but usually I need only $1,000. If the bank has a hundred customers like me, we don't really need $500,000 in total cash holdings. Maybe we can get by with $200,000. As long as we don't all need all of our cash at the same time, we can each have $5,000 in virtual cash holdings while having only $200,000 in actual cash holdings between us.

Under a fiat system, 100% reserve isn't so bad. If there's a bunch of cash sitting around in bank vaults doing nothing, the cash in circulation will just be worth that much more. But under a commodity money system, this is quite wasteful. Gold is useful for many things other than money, and if a bunch of it is sitting around in bank vaults when it doesn't need to be, it unnecessarily drives up the costs of using gold for nonmonetary uses, and prompts people to engage in uneconomical mining and exploration.

In this sense, a fractional reserve bank is analogous to a laundromat or a taxi service. It would be tremendously wasteful for everyone in Manhattan to have his own car or washer and dryer set. When only one person can use them, they remain idle for 90+% of their lives, so why not share them with others and split the costs?

Bart in Voice#1: "What do

Bart in Voice#1: "What do you mean the bank is out of money!?"
Bart In Voice#2: "We only have enough money for the next 3 people"
[Bank customers get agitated]
George Bailey: "We don't have your money! It's at....Bill's House...And...Fred's House!
Moe: "What the hell are you doing with my money, Fred?"
[riot breaks out]

What reserve status does the

What reserve status does the hat check girl advertise to her customers?

What would Eliot Spitzer

What would Eliot Spitzer say?

Regards, Don

Kip as is evident from my

Kip
as is evident from my post, I don't attach great significance to the ¨moral¨ argument about the gold standard (expressed in the hat analogy) because there are many better reasons to be opposed to it. However, I feel that the ¨your hat¨ aspect of the analogy highlights something you missed with your spigot analogy: the permanance and solidity of gold as a guarantee of currency rather the promise of the state (which is what's offered without specie backed currency.) While it's true that on a surface level it might not matter who's hat you're getting if all hats are the same, the desire for ¨your hat¨ makes a good proxy (if not a perfect analogy) for the desire for substance behind plain old paper currency.

Matt

I agree, but to be accurate,

I agree, but to be accurate, it's Katz' example, not Don's.

Your hat example is loaded:

Your hat example is loaded: you're asking people to assume, contrary to reality and perception, that "all hats are equal."

Assume instead that the commodity was a truly homogenous and fungible substance: perhaps oil, or wine, or salt or wheat. Assume also that depositors knew, in advance, that their deposits would not be kept separate but rather poured into a giant communal vat with a communal spigot at the bottom. If you make a withdrawal, it is simply poured from the communal spigot.

The only contractual promise made (besides interest) is that you can withdraw, on demand, as much as you put in.

Suddenly the word "fraudulent" sounds mighty inapposite. The fact that the vat owner can borrow the commodity on demand from other vat owners or the government's "central vat" only makes the system even less fraudulent.

If all men's hats are indeed

If all men's hats are indeed exactly the same (and yours is not broken in in a particular way or something) and you are guaranteed to always get your hat back (FHIC?) when you want it then what's really the problem? When you deposit money in a bank account, the contract you sign with the bank does not say that they will simply store the same exact cash that you give them. If you want that sort of security, you should get a lockbox. Rather, the contract says that you are entitled to get cash up to the amount you deposited whenever you like (or transfer your checkable deposits to some other person or whatever.) With the hat check girl there's an understanding that you'll get the same hat back. With a bank there's nothing that specifies what the bank does with your cash in the meantime. Given that, where is the fraudulence?

This seems correct enough to

This seems correct enough to me. I think however, that Hayek (in a quote that was posted last month) and probably most of you (dare I assume too much) misunderstands the reason why the bretton woods system was broken down, a history which was not about statists pushing the capitalists around, but rather speculative capitalist opporunists acting in their own interest. While it's quite clear the exchange system is probably immoral in a sense (following the above, quite evocative analogy) and that it does a lot of harm, it was set up by people looking to profit from it and use it to further the power of the "de facto government" of international banking (that's Fortune magazine's term for them by the way.)

-Matt

There are (at least) two

There are (at least) two issues with fractional reserve banking. One is effective disclosure and the other is what are its pragmatic consequences.

If you make a deposit of funds into a 100% reserve bank, there is at least an argument that can be made that you are not relinquishing ownership of your funds or at least their equivalent, and can reclaim them on demand, even if everyone else in parallel circumstances wants to at the same time.

In the case of a fractional reserve bank, this is not possible as the ownership rights in total exceed what exists to own. Thus, your deposit into a fractional reserve bank is effectively a loan to the bank.

If you believe that the present situation is fully and effectively disclosed, logic should imply that everyone who has their weekly wages directly deposited to a checking account would not flinch if you told them that they were really making direct loans to the bank for an interest rate of 0.5% or so. Disclosure has limited value if the targets of the disclosure are incapable of understanding all of its ramifications.

The consequences of fractional reserve banking include a credit expansion that creates new purchasing power that cannot be relied on to not go up in smoke at just the worst time. When marginal businesses and investments are induced into existence by the existence of credit that is not the result of savings, their rates of total failure will be be highly elevated and their very existence, however brief, injures non-marginal businesses as they bid-up and ultimately waste all kinds of resources. At least counterfeit money good enough to pass doesn't get destroyed and tend to produce an economy-wide contraction.

Regards, Don

I believe, the "fetish" is

I believe, the "fetish" is with gold having proven historically more stable than other resources, one with qualities that make it more attractive than many other resources.

Certainly someone can explain this better than I, as I have no particular problem with fractional banking. I would prefer the market select its own standard, whatever that may be.

Any commodity will do, but

Any commodity will do, but human civilizations have tended to settle on either gold or silver as the ultimate commodity, which turns into money. People's fixation on gold as a money is because that was the spontaneously derived money from time immemorial and thus could fill that role again. Also, gold is relatively scarce and as Scott alluded is hard to make more of (and thus by supply/demand will likely have more stable purchasing power than an easily duplicated money).

Ultimately, though, any commodity can do so long as it (a) has some tie to a traded commodity in the past and (b) retains its "most salable/tradable/liquid commodity" position. If nobody will take dollar bills in exchange for goods or services then dollars are only work the ink & paper they're composed of...

Other people have made this

Other people have made this point, but its so good I have to say it to.

Fractional reserve banking is only immoral if done in violation of a 100% reserve contract. There is nothing special about money that gives it different moral rules than any other good. And there is nothing fraudulent about issuing money which is fractionally backed, as long as your customers know that. To believe otherwise is to say that in this realm, contracts don't matter, and I think that is absurd. (Murray Rothbard has some wacky beliefs along these lines).

Furthermore, I guarantee you that fractional reserve banking will kick the shit out of fully reserved in an unregulated market place. Who would want to deposit their money earning 0 interest, when it could be put in diversified low-risk investments and earn a little? A "run" on the bank can easily be handled by a clause which says that the bank is allowed to suspend exchange for some period of time, and owe some interest penalty to note holders. As long as the bank is solvent, this prevents major problems due to illiquidity during a run. To learn more, read Larry White's work on free banking.

Ah, money, one of my

Ah, money, one of my favorite topics. Alas, everything worth saying on this thread has already been said. Still, I'll add this: 1) free banking would rock, 2) fractional reserves rock, and 3) gold is just a rock.

The Austrians despise both fractional reserves and fiat currency, which is why when Don posted about the evils of fractional reserves we veered off into the gold standard. But they're not strictly related. True free banking would dispense with fiat currency and state control over the money supply but would not require either commodity money or 100% reserves. I sympathize with the motivations of Mises and Rothbard, but we can do better.

Anyway, yes, contra the hat check example, fractional reserve banking is not fraudulent. It's not immoral. It's not even a bad idea... except when the government has a monopoly on setting reserve ratios.

How can the hat check girl

How can the hat check girl guarantee return of the hat upon demand and also lend out some of the hats? Some of the hat depositors would not get their hats back if they all decided to leave the hotel at once.

You are right, she can't unless she seeks some kind of insurance against hat runs. In the United States, banks are insured by the FDIC, which guarantees that depositors will be able to withdraw their money. The central bank may also decide to just print more money in a liquidity crisis. Guests at the hotel might demand that she buy some sort of insurance policy before they agree to let her lend out or sell some of the hats. Presumably this would all be included in whatever "contract" you had with the hat check girl. Bank runs tend to happen all at once so the market isn't very good at providing depositor's insurance. Hat runs probably are not correlated...

I’m not sure why this has

I’m not sure why this has anything to do with the gold standard, as you and others have mentioned.

I don't think Don or the quoted writer is saying anything about either gold or the gold standard in particular. The issue is whether or not fractional reserve banking is inherently fraudulent.

(As others have said, I don't think it is, as long as it's agreed by both the bank and the depositors beforehand that the bank operates at fractional reserves. I think that in a true free market for money, most banks would operate at fractional reserves and a few might operate at 100% reserve, the former being riskier, and the latter being more expensive. The choice of which bank to deposit to would be based on the risk tolerance of the depositor.)

If all men’s hats are

If all men’s hats are indeed exactly the same (and yours is not broken in in a particular way or something) and you are guaranteed to always get your hat back (FHIC?) when you want it then what’s really the problem? When you deposit money in a bank account, the contract you sign with the bank does not say that they will simply store the same exact cash that you give them. If you want that sort of security, you should get a lockbox. Rather, the contract says that you are entitled to get cash up to the amount you deposited whenever you like (or transfer your checkable deposits to some other person or whatever.) With the hat check girl there’s an understanding that you’ll get the same hat back. With a bank there’s nothing that specifies what the bank does with your cash in the meantime. Given that, where is the fraudulence?

How can the hat check girl guarantee return of the hat upon demand and also lend out some of the hats? Some of the hat depositors would not get their hats back if they all decided to leave the hotel at once.

If you believe that the

If you believe that the present situation is fully and effectively disclosed, logic should imply that everyone who has their weekly wages directly deposited to a checking account would not flinch if you told them that they were really making direct loans to the bank for an interest rate of 0.5% or so. Disclosure has limited value if the targets of the disclosure are incapable of understanding all of its ramifications.

Just because most people don't fully understand the intricacies of our financial system doesn't mean that the ignorant masses are being defrauded.

And even if it did, I think that the typical person is more than sufficiently informed about the nature of the funds they have on deposit. They know that they can get their funds back on demand, and that something called the "FDIC" has guaranteed it, no matter what happens to the bank. If you pointed out to them that they were essentially making a loan to the bank for 0.5% interest, they might be inclined to look for a higher return... which the bank would be glad to provide, in the form of a Certificate of Deposit. The drawback to a CD, of course, is that it's not callable upon demand the way a checking account is.

The consequences of fractional reserve banking include a credit expansion that creates new purchasing power that cannot be relied on to not go up in smoke at just the worst time.

I don't believe this, although Mises and Rothbard do. Competitive pressures between banks under a free banking regime would limit individual banks' credit expansion and currency inflation. In order to maintain convertibility with other banks' currencies, banks would ensure that their credit issuance was adequately backed with assets, namely well-performing loans.

theres no problem with

theres no problem with fractional reserve banking, as long as the use of force is ruled out, and the public is free to decide.thats not the case here and now. the public, over thousands of years,victim of myriads of gov't employees schemes to steal via inflation chose gold, even though liberal intellectuals still puzzle over why. i guess 4,000 years of evidence in its favour is a non interesting ho hum footnote to them.:idea:

Cornelius, good point about

Cornelius, good point about the role of reserve ratios under fiat money regimes.

As to commodity currencies: CornChips and HedoNotes would trade at par. Each would be worth 1/10 oz of gold and stores would accept either one at face value. The fact that there are 1000 Chips and 2000 Notes but only 200 ounces of gold (instead of 300) is quite beside the point.

Both currencies would trade at par because both can be exchanged for their face value of 1/10 oz gold: you'll give me gold for my Chips, and Patri will give me gold for my Notes. If someone thinks that HedoNotes are only worth half their face value because Patri is using that fancy-schmancy fractional reserve banking, then there will be plenty of other someones more than happy to give them 1/20 oz for their Notes (and then take them right over to the First Patri-Otic Bank and exchange them for 1/10 oz each for a tidy profit).

HedoNotes are worth full value because Patri redeems them at full value. They will trade in the currency exchange market at full value as long as everyone has confidence that Patri can continue to redeem them.

So what happens if there's a run on HedoNotes?

First, you've gotta understand that although Patri created his extra 1000 Notes out of thin air, he didn't just hand them out to random people wandering past his bank as a promotional gimmick. He made loans with them, and those loans are an asset that the FPOB owns. As assets, they have value, and can be bought and sold on the open market. If all of a sudden everyone wants to dump their HedoNotes and stuff their pockets full of shiny yellow lucre, Patri will be forced to sell his assets to get gold to meet his redemption obligations. This is bad news for Patri as it basically means he is out of the currency business, but HedoNote holders are well protected even as Patri's vast financial empire crumbles to dust around him; unless the FPOB's assets are significantly less than its liabilities, HedoNote holders will be able to get their gold back no matter how little gold is sitting in the bank's vaults at any given moment.

As long as Patri is prudent about managing his loan portfolio he'll always be able to meet his redemption obligations. And by acting as a credit broker between depositors and lenders he can make a tidy profit while offering a respectable interest rate on deposits.

I have a few thoughts on the

I have a few thoughts on the subject, and hope the train hasn't left the station.

Whether or not banks operate under fractional reserve is wholly irrelevant when dealing with a fiat currency system. In such a system, the money supply is entirely determined by the central bankers, and the reserve ratio is just another means for them to manipulate it. It's all just bits of paper.

Now, where reserve status does matter is in the realm of commodity currencies, and from here on out this is to what I will be referring.

There seems to be a misconception that a fractional reserve system is simply lending out idle money. This may be due to the sense of how our fiat currency works (paper in the bank is paper that is not in my wallet). The difference here is that with a commodity currency the commodity sits in the bank, and receipts for that commodity (i.e., currency) sit in someone's wallet, able to be spent alongside newly created receipts used to make loans.

In a free banking environment, where both commodity and reserve ratios were free to vary, some assert a fractional reserve system would out-perform a fully-backed one. I have my doubts.

Let's compare Patri's HedoNotes (issued by his 50% reserve bank), and my CornChips (issued by my 100% reserve bank). It would be legitimate to print "1/10 oz Au" on the CornChip, but what could be printed on the HedoNote?

With 100 oz. of gold in each bank there would be exactly 1000 CornChips in existance, but there would be between 1000 and 2000 HedoNotes in the world. Now we have a variable exchage rate between two ostensibly gold-backed currencies. Given this, it's easy to imagine a store demanding more Hedos than Chips for the same good (when fully loaned out, probably twice as much).

Altogether I have a hard time seeing how a small interest on deposits would garner more business than the inflationary prices would lose.

As to commodity currencies:

As to commodity currencies: CornChips and HedoNotes would trade at par. Each would be worth 1/10 oz of gold and stores would accept either one at face value. The fact that there are 1000 Chips and 2000 Notes but only 200 ounces of gold (instead of 300) is quite beside the point.

But that doesn't work. Suppose I have a bunch of HedoNotes, and I think that there's even a small chance that I might have some trouble getting my money back (even though I wouldn't lose my whole deposit in the event of a run, I'd probably lose some of it), I'll trade them in for gold and deposit it in your bank to get me some CornChips.

Patri has to have some edge to convince me to take a risk on accepting his currency. And that edge is probably that HedoNotes are interest-bearing bonds. They're not worth 1/10 oz. of gold; they're worth 1/10 oz. of gold plus two percent per year (or whatever), starting on the date of issuance. Or maybe CornChips lose value (to cover your operating costs). In any case, HedoNotes have to be preferable to CornChips in some way to offset the risk associated with holding them.

Patri has to have some edge

Patri has to have some edge to convince me to take a risk on accepting his currency. And that edge is probably that HedoNotes are interest-bearing bonds.

Excellent point. However, I think for currencies used as cash within a single area, the risks and returns will end up being expressed in ways other than via the retail-level exchange rate. For convenience, all banks will accept each others' notes at par at the banks' retail counters and will encourage all currency users (shopkeepers and customers) to do the same. Furthermore, banks will contract with third-party insurers who will guarantee that a covered bank's banknotes will always be redeemable in full at par with other currencies. If enough people accept Patri's notes at par, then almost everyone will accept them at par.

The banks will work hard to shield the public from the risk of accepting and holding any bank's banknotes. The residual risk will show up in the inter-bank clearinghouses; banks will evaluate each other's financial soundness and the risk of holding each others' currencies, and will charge each other different rates for swapping reserves. The various currencies will trade at par "on the street", but will have varying exchange rates when traded in bulk by the banks themselves (or by clearinghouses, or by very large currency traders).

Banks won't issue banknotes that bear interest on their face; nobody wants to use bearer bonds as money or calculate the interest accrued daily on the cash in their wallet. However, fractional reserve banks will offer interest to their depositors as an incentive to get deposits; the benefits will accrue to the *depositors*, not the note-holders.

You do in fact have an incentive to accept HedoNotes even though there is some risk that they may turn out to be worthless someday: everyone else is doing it. If you don't, then you'll miss out on some business from customers who only want to pay you in HedoNotes. Sure, that seems like a pretty flimsy reason to accept them, but when you get right down to it, that's the *only* reason to accept *anything* as money.