Why should fractional reserve banking be allowed? Why not forbid such an event as that you describe:
"The only difference between full reserve banking and fractional reserve banking is depositor's permission for bank's loan and depositor's sharing in the interest the loan is going to earn."
It's a very important difference. Without depositor's permission lending is a fraud! It's a crime on the depositor's property. There can never be two contemporary claims on the same amount of money.
Answer I:
The legislation forbidding fractional reserve banking would be as ineffective as the (alcohol) Prohibition Amendment.
From the standpoint of any banker, every demand deposit is a good source of funds for safe short-term loans, such as discounting of commercial paper.
The mere existence of demand deposits attests to their availability for loans to the extent they are not currently required by depositors. To forbid lending of funds that are sitting in bank's vault and are not required by their depositors would run against basic instinct of every banker. Such a law would be highly demoralizing because it would be uniformly and deliberately ignored.
While it is clear that fractional reserve banking is nothing short of conversion of depositor's funds, flat prohibition of this practice is not the kind of self-executing legal remedy that is required here. When every bank is made a mutual bank by operation of law, i.e., it is owned by depositors in proportion to their deposits, and the interest proceeds are paid back to depositors whose funds were used to earn them, it would be nearly impossible to find a court of law that would upheld conversion complaint under such circumstances.
If we cannot beat fractional reserve banking without destroying the banking itself, the best we can do to prevent converting of depositors funds by the banks is to make depositors the owners of the banks. Throwing bankers into prisons for trying to earn interest on available demand deposits is not the right solution.
Advocating imposition of a law prohibiting fractional reserve banking would paint the honest-money people as "the willing, led by the unknowing". Of course, the bankers are not going to like the idea of turning all banks into credit unions, but they will not be able to dismiss it by rational argument. If instead they were to fight the argument for prohibition of the fractional reserve banking, they would have no difficulties to show that the idea was impractical at best, for under honest money regime nothing could mobilize all available savings for credit purposes as efficiently as fractional reserve banking.
Question II:
This was taken from Rothbard's "Fractional Reserve Banking": ( www.lewrockwell.com/rothbard/frb.html ) "Let's see how the fractional reserve process works, in the absence of a central bank. I set up a Rothbard Bank, and invest $1,000 of cash (whether gold or government paper does not matter here). Then I "lend out" $10,000 to someone, either for consumer spending or to invest in his business. How can I "lend out" far more than I have? Ahh, that's the magic of the "fraction" in the fractional reserve. I simply open up a checking account of $10,000 which I am happy to lend to Mr. Jones. Why does Jones borrow from me? Well, for one thing, I can charge a lower rate of interest than savers would. I don't have to save up the money myself, but simply can counterfeit it out of thin air. (In the nineteenth century, I would have been able to issue bank notes, but the Federal Reserve now monopolizes note issues.) Since demand deposits at the Rothbard Bank function as equivalent to cash, the nation's money supply has just, by magic, increased by $10,000. The inflationary, counterfeiting process is under way."
In Rothbard's example, with fractional reserve of 1/10, bank lends the amount of existing reserve ($1,000) times the inverse of the fractional reserve (10) resulting in a total of $10,000.
In your example, with fractional reserve of 1/6, bank lends the amount of existing reserve ($100,000) minus fractional reserve of 1/6 ($17,000) resulting in a total of $83,000. And you specifically state time and again that having lent 5/6 of the existing reserve the bank has no more money to lend.
Why the banks in your example cannot lend the amount of existing reserve times 6? Take for example the first bank in your sequence (Corn Bank), why does it lend only $83,000 when Rothbard Bank would have lent $600,000 (6 X 100,000)?
It appears that Rothbard's fractional reserve banking and your fractional reserve banking operate on completely different principles. Which fractional reserve banking is the real fractional reserve banking? Will the real fractional reserve banking please stand up!
Answer II:
The article you quote proves that Murray Rothbard never grasped the real meaning of the fractional reserve banking. And Rothbard is not alone. This is not isolated error. Quite a few otherwise thoughtful individuals automatically assume that when required fractional reserve is say 1/10, the bank can lend its deposit on hand times 10, instead of only its deposit on hand minus 1/10 thereof.
Under fractional reserve banking, it is the banking system (not a single bank) that can produce a cascading series of deposits which will ultimately add up to the amount of the original deposit times the inverse of a fractional reserve (10 in Rothbard's example and 6 in mine).
To assume that the bank of original deposit can bypass this normal economic process by creating out of thin air and lending out the grand total -- which ordinarily the entire banking system would need to laboriously create one by one in a long sequence of business transactions -- is a childish error. Here is why:
If Rothbard Bank would have lent out only $900, the borrower would have given his check to his supplier who would deposit it in his bank, which in turn would have presented it to Rothbard Bank for payment in cash. And having $1,000 on hand (whether of his own or on deposit), Rothbard would be able to honor the check for $900 drawn upon his bank. The supplier's bank would then lend out $810 ($900 minus 1/10th), and so on, and so on... until the grand total of all descending loans in all subsequent business transactions would ultimately add up to $10,000.
But lending $10,000 with $1,000 on hand is a sheer folly. The presentation of $10,000 check for payment will put Rothbard Bank out of business the next day! Rothbard himself readily acknowledges this fact in the very next paragraph of the quoted article:
"[$10,000] ...will be spent on the goods or services of clients of some other bank, say the Rockwell Bank. The Rockwell Bank is not particularly interested in holding checking accounts on my bank; it wants reserves so that it can pyramid its own counterfeiting on top of cash reserves. And so if, to make the case simple, the Rockwell Bank gets a $10,000 check on the Rothbard Bank, it is going to demand cash so that it can do some inflationary counterfeit-pyramiding of its own. But, I, of course, can't pay the $10,000, so I'm finished. Bankrupt. Found out. By rights, I should be in jail as an embezzler, but at least my phoney checking deposits and I are out of the game, and out of the money supply."
Since Rothbard obviously can see (as this quote proves) that lending more than available reserves leads to immediate demise of a bank doing it, this begs the question why he never re-examined his understanding of the fractional reserve banking.
If all the banks were to administer fractional reserve banking the Rothbard's way, they would all cease to exist within a week.
Question III:
In an article titled "How To Defang All The Banks Once for all" author J. N. Tlaga takes on "the dean of the Austrian School of economics" to argue that "Fractional reserve banking per se cannot produce new money out of thin air." Using a set of examples, his main argument is that, contrary to Mises, fractional reserve banking and full 100% reserve banking are identical in their effects on the money supply. Tlaga seems to believe that Austrians hold to the view that gold is the only component of the money supply. The hint is given in this sentence: "Such banknotes are being used in daily trade as convenient substitutes for gold coins (Ludwig von Mises will correctly call them "fiduciary media", for they are not money, they only represent money)." Unfortunately this is a misinterpretation of Mises. Austrians do consider banknotes to be a component of the money supply, which is why expanding them amounts to the creation of money out of thin air.
( Posted at www.mises.org/blogDetail.asp?control=1317 )
Answer III:
The issue whether fractional reserve banking can (as Austrians maintain) or cannot (as this author observes) create new money out of thin air merely by expanding supply of banknotes, may only be resolved by showing its practicality or impracticality, rather than by resorting to sophistry, e.g., "Austrians do consider banknotes to be a component of the money supply, which is why expanding them amounts to the creation of money out of thin air."
Let us make our case as simple as possible, step-by-step:
Step One:
Corn Farmer deposits 100,000 dollars in gold coins at Corn Bank, and receives 100,000 dollars worth of Corn Bank banknotes, which declare that Corn Bank will pay to the bearer on demand the face amount of dollars.
Any new money was created out of thin air thereby?
None at all! 100,000 dollars in gold were removed from circulation and were placed into Corn Bank's vault, while corresponding 100,000 in fiduciary paper "dollars" were removed from Corn Bank's vault and placed into circulation.
Step Two:
Corn Bank issues additional load of 83,000 dollars worth of its banknotes to Alcohol Distiller by discounting his 90 day commercial paper of the face value of 83,750 dollars. In other words, Corn Bank has just lent 83,000 dollars to Alcohol Distiller for 90 days in exchange for 750 dollars in interest.
Any new money was created out of thin air thereby?
Here comes the controversy:
The Austrian gentlemen say:
Yes, 83,000 new dollars were created out of thin air thereby.
J. N. Tlaga says:
No, not a single new dollar was created out of thin air thereby.
To remove any possibility of misunderstanding, real or pretended (hecklers often pretend not to understand the point they nonetheless attack), let us provide yet another explanation in simplest possible terms why the fractional reserve lending does not and cannot create new money out of thin air.
At first glance, the Austrian case appears valid beyond any dispute. Corn Bank issued 183,000 dollars worth of banknotes against 100,000 dollars in gold coins. There are now 83,000 dollars worth of banknotes more in circulation than the gold money they represent. Hence, 83,000 new dollars were created out of thin air. But then comes the Step Three, which demolishes this fallacious reasoning.
Step Three:
Alcohol Distiller gives 83,000 dollars worth of Corn Bank's banknotes to Potato Farmer in payment for a trainload of potatoes, Potato Farmer deposits them to his account in Potato Bank, and Potato Bank presents them to Corn Bank for redemption. Corn Bank transfers 83,000 dollars in gold to Potato Bank, and puts 83,000 dollars worth of banknotes back into its vault.
Which money was actually lent to Alcohol Distiller? Gold coins or banknotes? Gold coins, of course. Banknotes were merely used as a transfer device, and they were accepted "subject to collection", just like checks. When a merchant advises us that our merchandize will be shipped after our check clears, he tells us that our check is not a money sensu stricto, it is merely an instrument used for transferring money; when the real money is received, the shipment will be made. This should not be difficult to understand.
And so, 83,000 new "dollars" allegedly created out of thin air, vanished, not so much into thin air as back into Corn Bank's vault.
"But this does not eliminate 83,000 new dollars that were created by Corn Bank's loan to Alcohol Distiller" -- the Austrian gentlemen may say. "Now it is Corn Farmer who is holding the surplus of 83,000 dollars, because Corn Bank has only 17,000 dollars in gold coins in its vault. One way or the other there is 83,000 more paper dollars in circulation than supply of gold dollars they represent."
What is our response to this argument?
Out of 100,000 dollars worth of banknotes kept by Corn Farmer, only 17,000 are dollars -- that can rightfully be counted as part of money supply -- because they can be redeemed in 17,000 gold dollars kept in Corn Bank's vault.
The remaining 83,000 dollars worth of banknotes ceased to be counted as dollars in circulation and became certificates of deposit (earning no additional interest as time deposit should) the very moment 83,000 gold dollars were shipped from Corn Bank to Potato Bank.
When gold and silver coins are legal tender for debts, and banknotes and checks are mere instrumentalities for making payments in silver and gold, banknotes and checks may be counted as money only when they are instantaneously redeemable. Once the gold available for redemption is no longer there -- because it has been lent to a third party for example -- banknotes and checking accounts can no longer be counted as money, only as a form of bank's certificates of indebtedness.
Corn Bank lent out not the new dollars created out of thin air, but the existing gold dollars kept for redemption of banknotes in possession of Corn Farmer, and to the extent of that loan, Corn Bank unilaterally invalidated the monetary value of Corn Farmer's banknotes (by withdrawing without notice its solemn promise to redeem its banknotes in gold dollars).
If by chance, Corn Farmer had an emergency and redeemed his 100,000 dollars worth of banknotes into gold dollars before Alcohol Distiller's banknotes were presented for redemption, Alcohol Distiller's loan would have been changed into a mere promise of a loan because his banknotes would no longer have the power to execute this loan by conveying its proceeds to the borrower (having just lost their ability to transfer the money they represented).
Ultimately, the fractional reserve fallacy of the Austrian school can be nailed to the wall in a dozen words, and here they are:
To exist, new money must circulate parallel with the existing money supply.
Against the famous advice of Albert Einstein -- that explanations should be as simple as possible, but not simpler -- we will try to transform this dozen words into an airtight argument.
For as long as "fiduciary media" -- banknotes and checks -- are required to be redeemed in gold to constitute a legal tender for debts, they cannot circulate parallel with the existing money supply, out of necessity they can only circulate in lieu of the existing money supply. The only money that can circulate as valid legal tender in addition to and not in lieu of the existing money supply is the fiat money, which proclaims on its face "This Note Is Legal Tender For All Debts, Public and Private". It is this "legal tender" declaration on the face of the fiat money that allows for simultaneous circulation in addition to, and not instead of, the existing money supply. Mere possibility that Corn Bank's banknotes may turn out to be irredeemable denies them the status of money until they are actually redeemed, which means that banknotes can be irreversibly counted as money only when they are withdrawn from circulation, i.e., when they cease to exist, ergo, they cannot circulate simultaneously with the gold money they represent.
Let us try yet another explanation to leave no loophole for ignorance to sneak in and thrive:
Under honest money regime, there were two other forms of "paper dollars" in circulation: gold certificates and silver certificates.
I have in front of me a Five Dollars specimen of silver certificate. It proclaims on its face:
THIS CERTIFIES THAT THERE IS ON DEPOSIT IN THE TREASURY OF THE UNITED STATES OF AMERICA FIVE DOLLARS IN SILVER PAYABLE TO THE BEARER ON DEMAND.
In 1900, when Gold Standard Act became the law, 410 million dollars in silver certificates and 210 million dollars in gold certificates were in circulation.
Is there any heckler anywhere claiming that when US Treasury injected into circulation all these silver and gold certificates, it increased the existing money supply?
Of course not. Because for every such Five Dollars silver certificate or gold certificate, five real silver dollars or five real gold dollars were removed from circulation and placed in US Treasury vaults.
We never had both the certificates and the silver and gold they represented in circulation at the same time. When certificates were in circulation, silver and gold was out of circulation, and when certificates were redeemed, silver or gold they represented would return to circulation while certificates were withdrawn into US Treasury vaults.
Why then, the same people -- who can understand that silver certificates and gold certificates cannot circulate simultaneously with silver and gold coins -- they seem to be unable to comprehend that banknotes, which are also redeemable in silver and gold, cannot circulate simultaneously with silver and gold coins they represent?
Corn Bank's banknotes are issued from its vault in exchange for gold coins that are placed into its vault, and are returned to its vault in exchange for gold coins that are shipped out of its vault.
When Corn Bank lends some of the gold coins on deposit to a third party, the corresponding banknotes are downgraded to the status of certificates of deposits. They still have claim to receive gold coins, but they cannot execute that claim immediately; they have to wait until the loan is repaid.
If 83,000 dollars worth of banknotes issued by Corn Bank to make a loan to Alcohol Distiller could validly expand money supply, both Alcohol Distiller and Corn Farmer should be able to withdraw their deposits in gold at the same time. In our example, only one of them can. The other one has to wait.
Outside of this example, in the real world out there, Corn Bank has many more depositors than Corn Farmer alone. For this reason, Alcohol Distiller and Corn Farmer would be able to cash their banknotes at the same time even though they have conflicting claims to the same gold, because gold deposits of other clients could be used to bridge this shortage. This is one of the reasons why so many otherwise intelligent people accept this openly irrational theory that fractional reserve banking can create new money out of thin air without giving it a second thought. This author used to be one of them. And this leads us directly to the Question IV.
Question IV:
I can understand your argument. What I cannot understand is why von Mises accepted for the face value the theory that new money was being created out of thin air by fractional reserve banking?
Answer IV:
Part of this answer was already provided in the closing paragraph of the Answer III. The mere fact that conflicting claims to the same gold could be satisfied at the same time must have been confusing enough. But the real reason was of more broad, fundamental nature.
The theory that fractional reserve banking was creating new money out of thin air was fitting neatly as a solid pedestal for Austrian theory explaining boom-and-bust cycles in economic life.
No one can deny the existence of boom-and-bust cycles, and no one can deny that influx of the new money is their primary cause.
But was it the fractional reserve banking that was the source of this new money?
We have already explained that fiat money is the only money that can effectively expand the existing money supply. "Fiduciary media", which must be validated as money by way of their redemption into commodity money (silver and gold), cannot be redeemable in silver and gold and at the same time add on new money in addition to silver and gold.
Fiat money can be printed by the government or by the central bank.
In 1900, the United States still had a leftover of $322 million in US notes from the Civil War. A Two Dollars specimen I have in front of me contains two inscriptions on its face:
On the left side under red seal of US Treasury:
THIS NOTE IS A LEGAL TENDER
AT ITS FACE VALUE FOR ALL DEBTS
PUBLIC AND PRIVATE.
And the main inscription in the center:
UNITED STATES NOTE
THE UNITED STATES OF AMERICA
WILL PAY TO THE BEARER ON DEMAND
TWO DOLLARS
During initial 17 years, from 1862 till 1879, the United States of America would not redeem such notes and no one would accept them at their face value; the discount rate varied depending on how likely it seemed they might be redeemed eventually. In 1900, the US notes were secured by $150 million redemption fund in gold, and were accepted at their face value as "lawful money" for all purposes except for import duties. They formed a stable part of US money supply, very much the same as silver and gold certificates.
Their circulation did not increase and decrease periodically to account for boom and bust cycles.
Another possible source of fiat money, the central bank, was not yet in existence.
Thus the fractional reserve banking was the best culprit available. There was no need to dig underneath to verify that it was the real source. Its guilt was assumed without proof.
For the purpose of this answer we can add little to what was already said in the original presentation:
"The problem should be seen in global perspective, because the fact that one country does not have central bank is not a guarantee against invasion of the bankers from another country which has one. For example, American boom and bust cycles were caused by predatory interventions of the English banks whose ample gold funds were made available by replacing gold with the sterling bill in international shipping, monopolized by the British shipping firms and London bankers. Being unaware of the predatory interventions of the English banks, the Austrian gentlemen had to attribute those booms and busts to something, and the only explanation they could come up with was that fractional reserve banking was increasing money supply and thus was causing those booms and busts."
This presentation must be interrupted at this point, for it already exceeds 38 hundred words, but it will be continued. Part 2 will begin from lucid explanation why this issue is very likely to determine the ultimate outcome of the coming struggle for restoring honest money. Many valid questions remain to be answered and many new are coming in.
13 January 2004
J. N. Tlaga
jtlaga@bellsouth.net