How I Learned to Stop Worrying About Fractional Reserve Banking and Start Hating the Fed Even More than Ever
I’ll get back to you later. Off to a semi-long drive. I think we have a misunderstanding between notes and debt, but I’ll get back to that. Otherwise, I think we agree any system that uses debt risks collapse. To me, the question is which of these systems, all of which will suffer credit collapses, causes the least amount of damage to society when collapsing? I’ll be sure to ponder this as I drive. Cheers,
Here’s my take on fraction reserve banking:
I see the fractional reserve principle applied uniformly to all bank deposits as a negative thing. FRB and secondary lending with their multiplier effect, multiplies any underlying fluctuations in the base money supply which I believe exacerbates the boom/bust cycle, creating massive highs and crashing lows. While the underlying money supply would much less volatile under a "sound" money system, there is still potential for hoarding/flooding cycles which would be multiplied by FRB.
I also see the banks as having a disproportionate control over wealth as granted to them by FRB; money that isn’t theirs yet they are able to lend as if it was, thereby making a disproportionate amount of money for themselves off other’s money.
I think banks have combined to opposite duties into one: first duty, store money, second duty, grow money. Inactive, stored money cannot grow and growing money cannot be stored. FRB tries to get around this problem (by lending out some/most stored money to grow) but creates a few problems of its own (multiplier effect).
I think it’s important to differentiate between fractional reserve lending and secondary lending. Fractional reserve lending can work if it is decoupled from secondary lending. I see it as completely unenforceable to prevent secondary lending therefore other avenues must explored to prevent massive multiplier effects. I propose that 100% checking accounts would provide a brake on secondary lending (by banks), decoupling the multiplier effect from fractional reserve banking.
Checking account deposits should be 100% reserve: the bank should not be allowed to lend out on your money when you are placing with them for safe keeping. Granted, you pay a service fee for the convenience of having your money safely held and the convenience of being able to use a debit card instead of paper and coins.
Savings accounts can be any percent (0% to just under 100%) reserve and the money needs to locked in for a set amount of time. At 0% percent reserve the bank is really just acting as an investment advisor and a facilitator between the saver and the person asking for a loan. At say 50% reserve, the benefits (interest earned on savings) are less than those benefits at 0% reserve because the risk is lower: less money was lent out to earn loan interest, and the you can extract up to 50% of your money without penalty which gives the added benefit of flexibility. The higher the reserve %, the lower the interest on savings. And obviously, the greater the maturity, the greater the interest on savings. Banks could also provide savings insurance so all is not lost on a loan default.
Example: someone wants to save $1000 (and is willing to part with it for some fix amount of time). Someone else needs a $1000 loan. The bank is the loan finder, loan vetter, and facilitator to transfer the saver’s money to the borrower and the bank takes some of the interest on the loan. The borrower then deposits the money in his checking account to pay for whatever he borrowed the money for. In this example, the bank has no reserve for the savings account money; all of the money was lent. Yet, the money hasn’t mushroomed into infinity times the original amount because the secondary lending is stopped when the money is deposited in a 100% reserve checking account.
Granted, the borrower could save a fraction of his loan in a savings account which in effect makes him a fractional reserve bank. But the likelihood of every borrower being a saver (and therefore lender) is much less than the current system of banks where every bank is a lender on every deposit (checkings and savings). 100% reserve checking would prevent the dozens of iterations stemming from FRB and secondary lending; there may a few iterations but definitely not of the same magnitude.
All these systems already exist in some form, yet all of them are not found in our banks. I think the real the issue is education. If people knew how banks work, they would active seek alternatives which would, in turn, spur the banks to change (or fail). And yes, central banks need to go too.
I read some criticism for it on this thread but I think Money as Debt is definitely worth the watch. Video and my thoughts here: http://econcell.blogspot.com/2009/06/money-as-debt.html
Also, for the a closer look at the feasibility of interest and FRB, check out the disputed section of Money as Debt: http://paulgrignon.netfirms.com/MoneyasDebt/disputed_information.html
If you really want to hate the Fed, watch The Money Masters. Video and my thoughts here: http://econcell.blogspot.com/2009/06/money-masters.html
Patrick Brown wrote:
Otherwise, I think we agree any system that uses debt risks collapse.
Right, we’ve nailed this one down. If you lent out gold over and over again, you’ll need exponential growth to perpetuate also. Exponential growth cannot work by definition. All you do with the gold money is to limit the money expansion by market forces, actually the gold mining market. Thus, you would inevitably get short on gold, inevitably cut lending, cut liquidity, and force the economy into a gold market triggered downward spiral.
Furthermore, some heretical market forces questions about systems that serves society and generate damage to society:
With reference to what’s been said above, the majority of market participants, or let’s say people, will get short on gold. A diminishing minority will get gold on gold in abundance. We know that the theoretical end of the game is reached when one owns it all. This phenomenon hurts the economy. Would a government be able to tax this phenomenon away in a globalized world? Isn’t it easier to install a money-inherent tax with global effect?
From the public view, what’s more important: to maintain sound asset values, or to maintain economic activity and liquidity? Isn’t it from an economics viewpoint understandable to install a mechanism that grants up-and-coming individuals access to existing values (as presently exercised through thin air money) by implicitly and silently redistributing former accumulated values? Obviously fiat money isn’t the best solution, but sound money won’t be able solve the problem on an equal rights basis.
And a final remark with regard to an asset value based economy: if you run a business of making things, and you want to continue to run the business, then you need to continue to have customers. You probably shouldn’t give a damn what’s the asset value of your business, but you should care about your ability to add value to your customers whilst generating minimal waste. In our world this means more and more to focus on intangible assets, exactly people. Wouldn’t a sound money economy even increase an investor’s pressure to focus on plain tangible stock value? Would this improve our competitiveness?
Gold limits the amount of saving/leverage the economy can tolerate. This limits growth (bad) but also limits debt (good) at the expense of regular deflationary depressions.
My preference is to recognise that commodity money does nothing to ensure economic stability (it prevents the worst of bubbles but on the flip side it unreasonably constrains growth even in good times leading to unnnessecary depressions), and that instead perfect economic stability can only be ensured by eliminating any arbitrage which prevents the savings/loans market from being cleared.
That arbitrage is cash and other 0% anonymous bearer instruments. I see no reason why savers should be treated preferentially to borrowers and therefore -ve nominal interest rates should be allowed under true free market conditions.
Hi Patrick, hope you had a good drive through what was recently rated the #1 country in the world based on the Happy Planet Index!
Back to discussing the miserable US where the unchecked power of banks has driven us to an ever-increasing velocity of life based on a utilitarian existence… 🙂
Most of your dialogue has assumed away interest or said it’s a minor issue because banks pay interest on the deposits as well. While it is necessary to assume it away for a bit to evaluate the core transactional model, it’s a massive issue. It’s THE issue from an economic perspective (the bigger issues in my opinion, as I’ve said, are moral, sociological, ontological, philosophical, etc but it seems we don’t want to discuss those in this thread).
So why am I suggesting interest is THE issue? It requires the macro lens I’ve been talking about instead of the micro lens. Assuming a modest 3% spread on assets/liabilities it takes just 23 years for the banking system to inherit the entire wealth of what the economy was at year 0 via interest payments. So at year 23 there’s 2X the economy (poker chips on the table), but another 1X has been pocketed by bankers (and then only another 14 years for the next 1X based on the power of compounding). This powerfully illustrates the need to further inflate because it’s impossible to keep the apparent 2X alive without making it 4X in another 23 years (requiring another 2X in interest). And they don’t really care once the system deflates after a 23 year cycle or 2 because they’ve put the equivalent of the entire economy in real stores of value while the illusory store of value (bank deposits) they created for everyone else deflates.
That’s the basis for exponential growth. That’s the basis for continued inflation as the loaning must continue. That’s the reason banks become the biggest capital holders/owners of the world over time.
That’s the reason banking families become the aristocracy. It’s an unmatched long-term wealth generation machine that requires no productive work. It’s solely based on the right to pass people’s money back and forth…galactic incentive for the sons and grandsons to do whatever is necessary, no holds barred, to maintain the system and they have the wealth/power to do so.
Strabes is right, which is why the free market is trying to set negative interest rates, and the central banks are trying to accomdate that via inflation. Except that tool is now broken now we’re at ZIRP.
The only possible free market solution to refloat a capisized capitalism while preserving the primacy of private enterprise is to allow the market to set rates at an appropriate negative rate until sufficient wealth has flowed back the way it came.
I have yet to hear a good argument as to why say -2% nominal interest rates would create instant hyperinflation or a collapse of the monetary economy. Of course, something has to be done about cash, which has its own issues with regard to personal liberties etc. However the entire progress of humanity has been the story of exchanging one liberty for another. There are no free lunches in this regard.
scepticus, I like the idea of letting negative rates drive a decentralizing flow of wealth the other direction. You’re right it wouldn’t lead to hyperinflation…because credit flow doesn’t equal "printing money." However, I think I prefer the simple idea of jubilee…after a certain period all debts are cancelled and interest wealth generation machine of the bankers is shutdown/reset. Bankers should not be allowed to keep the machine I described above flowing because the longer it runs, the more it returns us to the economic strata of feudal times. This would generate a discontinuous adjustment (a euphemism Greenspan used because he didn’t want to say "disastrous collapse"), but that’s coming one way or the other.
accelbell, I like the idea of 100% reserves on checking…that is a good rule to adopt at a minimum I think. Not sure it would do much to solve our current problems though given that checking/savings (M1) are a tiny portion of overall money/credit (M2/3/derivatives). I think the most important issue is to get ALL measures of money/credit back ON the balance sheets as Volcker has been pushing, and then develop a better regulatory system for debt/equity measures. What Wall St did with regard to debt/equity was an absolute crime from a human perspective and in my view once the system is stabilized, the lords should be put in prison, or forced to live with families that have been foreclosed upon. Those money lords are a disgrace…the "worst of the criminal class" as Teddy Roosevelt called them.
Patrick, how have you demonstrated that a world without banks could have more debt? I believe that’s impossible…an economy with a banking system generating its money (based on the last several posts I think there’s still a loose use of the terms money, currency, credit, debt resulting in some of our disconnects) is by definition a debt-creation machine. Was it that banks have the statutory reserve requirement whereas private people don’t? That wouldn’t make people create more debt than banks because reserve ratios aren’t the true limit on debt. Debt/equity ratios are. Private individuals without distortions from government would never and could never lever up to the degree banks do because they approach worthlessness as they lever up and there’s a severe cost to personal bankruptcy (whereas banks become, in appearance, worth MORE as long as the inflationary cycle continues…they must lever up until deflationary pressures takeover). A bank could theoretically have an infinite debt/equity ratio because their basis for growth and interest wealth is Assets Under Management rather than Return On Equity like other businesses and individuals. That’s why M2/M3 and derivatives became so huge and the latter was kept off the balance sheet.
Banks aren’t stewards of equity…they are accumulators of "assets" in order to continue amping up their liabilities to generate interest wealth. Every other institution/person must be a steward of equity…and therefore would not generate as much debt.
Debt Level, Money Supply and Banking
Debt can exceed the money supply in any system, with or without Fractional Reserve Banking and even in the absence of any banking at all.
I tried to show this before, but I will try to do so in more detail here.
I hope we can all agree that any individual in a society can freely lend to any other individual, without a bank acting as an intermediary.
Most types of loans are made in exchange for full ownership rights over an asset. This could be land, a house, vehicle, or some other durable good.
Other loans can be made in exchange for a service, in which case the creditor has no recourse should the debtor fail to pay. You cannot repossess a service as it were.
Still other types of loans do not even involve money. Other assets can be lent such as land rights (occupation, farming, mining, fisheries or aerial rights), or livestock for example. These loans are more commonly called “renting”, but since they involve the transfer (albeit temporarily) of an asset from one person, the creditor, to another, the debtor, in exchange for a pre-determined value, usually money, over a pre-determined time period, they are just like loans in that debt is created. The total amount of value to be exchanged over the time period, or the penalty for early termination, is the debt created.
Given all this, let’s examine some examples to see if debt can exceed the money supply:
If I needed to purchase a car from you, but didn’t possess all the money to do so, maybe you would be willing to let me pay you 20% down and the rest in 36 monthly installments at 10% annual interest. If the car cost $1,000, that would mean I give you $200, while $800 plus the interest is created as debt.
Already, we have more debt than money.
However, this is just the beginning. You could then take those $200, and use them as a down payment on a new $1,000 refrigerator you need (OK, it’s a very nice fridge). You convince the seller you have the ability to pay for the rest of the fridge based on your income. Now we have $1,600 in debt on top of $200 of money.
The fridge owner now takes the $200 and uses them as a down payment on a $1,000 new crib and set of baby toys for his newborn. Now we have $2,400 of debt on top of $200 of money. And that doesn’t include the interest.
Must I go on?
In the meantime, both you, the car seller, the fridge owner and the crib seller all live in homes you bought using $10,000 in savings and each borrowed $40,000 from the developer (OK, they’re shitty little trailers – NOI).
Doesn’t seem like banks are needed to incur more debt than money to me. On the other hand, there could be a giant concept I’m missing here and if so, please help me out and show me what it is.
Now I know one of the arguments I’ll hear is, but this would be very slow and cumbersome, always trying to find a willing lender. Yeah, probably. I agree banks facilitate it. I didn’t say as much debt would be created as quickly. I only said it is very easy to create more debt than money in any society, banks or no banks.