The Dupes of Fractional Reserve Banking

I had a discussion with a commenter called Midwesterner at Samizdata back in March that will give a fairly good idea of my understanding of fractional reserve banking. I thought it was a useful exercise for both Midwesterner and myself, and is one of those rare occasions on the internet where there was a changing of minds.

Midwesterner had posted a comment which included a hypothetical situation and his interpretation of it.

"Let's you and I play Monopoly™ some time and see how it works.

Lets say nine players start with 100 dollars each and all sales are done at open auction (simulates the market). Democratic vote will decide which players may engage in fractional reserve lending (simulates politics). Everybody else can only lend hard currency.

Lets say four players and I collude to engage in preferential treatment of each other. We five can use fractional reserve the other four cannot.

To keep it simple, let's say the other four colluders (in the real world, a couple of dupes would, too) all deposit their money with me and I lend it back to them. We have an initial kitty of 500 dollars (mine and their $100 starting stakes). By practicing fractional reserve lending I can actually loan them by the tenth deposit/loan cycle a total of $1785.25 (5 x $357.05) . This assumes that the player they spend the loan with turns around and deposits the money with me. So the five of us now have $1785.25 to bid against the other four players $400. We could actually have almost $1000 each if we managed to ring every last cent out of the system. By borrowing for all of our expenses and depositing all of our receipts, one can see how quickly the game would shift to the five of us with each lap around the board.

Players not in the lend/borrow/lend/borrow/.../... system have $100 each to spend. People in the system have $357.05 each to spend. Needless to say, a little collusion goes a long way. Separating the players from the dupes in this example makes the racket a little more obvious."

So what would be your answer to this and why? Do you think you would be able to give an explanation that would convence Midwesterner of your position?

Well surprisingly, I was able to convince him that in fact he was wrong, and along the way this exercise lead me to realize some things that were implicit in my beliefs but that I had never explicitly derived.

This was a series of comments exchanged on fractional reserve banking that also touched on anti-empiricism in Austrian Economics.

Turns out the only dupes in the system were those holding the bank accounts and accepting the bank notes and not the non-participants.

Here's my first salvo:

"Midwesterner,

Their are restrictions on who can collude which prevents the collusion from being as easy as you make it out.

First off they have $500 between them. No matter how they lend the money out to each other there is still only $500.

When they borrow they must have access to the possibility of buying an asset with a revenue stream in order to service any loan they may take out to buy that asset. However in your example there are no assets with revenue streams.

Even if there were if any back and forth lending and purchasing occurs betwen the 5 colluders then the net benefit to them is zero.

The non-colluders could always decide to lend to each other also. So there is no asymmetry of fairness there. Nice player a could lend to nice player b who happens to buy a performing asset with the money. He then provides a with part of his revenue stream to service the interest on the loan. Player a no longer has the money he lent to b. He only has a promise to pay it back based on the revenue stream. So a has less cash on hand. As long as a understands this and doesn't think he can just retract the loan at any time then there is no problem.

Any "collusion" that occurs between the five colluders requires one of the colluders to lend and one to borrow with a net gain in cash of zero. Of course colluder c1 is not going to lend to c2 out of the goodness of his heart. He going to want proof that c2 can pay him back with interest.

So your model here is not sufficient to capture the nuances of the issue of fractional reserve banking. It's not merely that every schmoo on the street is harmed by people lending money to each other. There is something more that goes on.

Hint: There is a problem if and only if any player a lends to player b with b buying a long term capital asset that only has a revenue stream sufficent to pay back the loan, while telling a he has the capability to pay him back fully with cash out of hand he doesn't have.

This however is a fraud between a and b and doesn't involve the other people, and gives a no ability to bid up prices in the economy. Player a may overspend on his budget based on his mistaken trust in player b but that's only his problem when he runs out of cash and b can't pay him. That does not effect any person who is not lending to player b.

There's no reason why a bunch of players might cooperate, not collude which is a loaded word, to pool their cash on hand, just in case any one of them has an emergency.

I leave it to you to figure out how banks play a role in this."

BTW, there was another good article on Samizdata on the role of China in this crisis. It's something I recognized more than a decade ago. I've commented in that post also and although it's a rushed comment I think it would be helpful for anyone who doesn't understand why some people oppose loosening credit as a response to the crisis.

Remember these comments in the second article are not polished in a way that makes them easy to understand, unlike the comments to the first article. Repeatedly explaining this will help me understand why people can't grasp the argument and I will improve it.

I understand the causes of this problem, I understand the current situtation, and I understand the proper "solution". Getting anyone else to grasp it is another matter.

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What is your "solution"? I

What is your "solution"?

I find that the answer to that question defines a person's core philosophy, and I am curious as to yours.

solution is honest book keeping.

The books always balance. Cooking the books should be a hanging offense. The problem is that the government only keeps a cash account. If the federal govt was required to use double entry books it would be much harder to cheat.

Much of the money spent is NOT on the books, the war, black ops . . . .

The argument about fractional reserves when "money" was a sort of credit slip that could be replaced by real metallic gold and silver. 90% of the money in existence is electronic transfer. Less than 2% of the money is cash - folding or clunking.

Money is no longer a thing. Money exists in the same way that work hours exist or that the conversion factor between degrees F and degrees C exists. Money is a handy way to compare the economic values of say, apples and oranges and shirts. Money also functions as an IOU. Money has no value unless it is put to work by lending it at interest or is traded for a hard asset. You could have all the money in the world but if I have all the food left in the world or the only insulin left in the world and we both need it . . . .

Which is better for majority of the people? When the world was on the metallic gold standard 80% of us were working poor and didn't have any gold, only a few coppers. It was the expansion of cash and credit that created the large middle class. If it is not sustainable then neither is the middle class.

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Money From Nothing

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-Roman Be