I recently wrote two notes on Facebook on the subject of "fractional reserve banking" that I reproduce below. If you want to see the discussion, click here and here. There were a couple of objections that I did not answer or answered very sweepingly; time permitting, I will return to them later.
Earlier on the same subject: Is "fractional reserve banking" compatible with Objectivism?
Should pick-pocketing be legalized?
Yes, why not? Pick-pocketing is a market phenomenon, and phenomena appearing in the market, springing from the market itself, should not be criminalized. Pick-pocketing appears on the market – it is not the result of government interference – and it springs from the market itself, not from something outside the market. The proof of this is simple: if there were no market, there would be no pockets to pick. Also, if a person goes to a market-place, he must be aware that there may be pick-pockets operating in that market-place; if he is not cautious enough to avoid being pick-pocketed, he has only himself to blame: it was a calculated risk he took, merely by going to that market-place.
Well, perhaps you sense that there is something seriously wrong with this argument.
But I constantly hear this same argument with regard to fractional reserve banking. In a society with free banking, it is said, fractional reserve banking would have to be legal, because it is a matter of agreement between the banking granting a loan with fractional money and the person taking the loan. Both parties are aware of the risks involved, and both parties are willing to take that risk; so what’s fraudulent about this?
This argument by-passes a point I have made several times: the defrauded party in fractional reserve banking is neither the bank nor the customer taking the loan: it is everybody else. Fractional loans will have the same effect that every expansion of the money supply has: prices will go up. But the person taking the loan will be in a position to buy with his loan before prices have risen; other people are in the opposite position of buying after the prices have gone up. The loaner gets an unfair advantage over the non-loaner. The non-loaner, is in fact, defrauded. His pocket has been picked.
But this simple point (simple to students of “Austrian” economics) does not get through to non-Austrians.
For example, I just yesterday read a comment here on Facebook to the effect that the “Austrian” opposition to fractional reserve banking (spelled out in simple terms by George Reisman and in more complex terms by Ludwig von Mises) is a symptom of the “rampant rationalism of the Austrian school”.
Well, to answer with the same coin, this is an example of the “rampant empiricism, and the capacity of complete misintegration, of some people claiming to be Objectivists”.
A Thought Experiment
(Follow-up to “Should pick-pocketing be legalized?”)
Let me make a thought experiment. Imagine an economy with no central bank and no government intervention. In this economy there are only two banks; let’s call them the Mulligan bank and the Lawson bank. Both banks are gold-based, and they both issue bank notes backed by the gold in their vaults. The denomination of the notes is rand, and one rand corresponds to one ounce of gold. (I choose rand, because a Krügerrand contains exactly one ounce of gold; but if you want to associate to a famous writer who advocated the gold standard, that’s OK with me.)
The Mulligan bank is careful not to issue more notes than are actually covered by the gold in its vault; it operates on a 100% gold standard. The Lawson bank, on the other hand, is not that careful: it issues more notes than are covered by its gold; it’s on a “fractional” gold standard. (We can assume, for example, that its gold reserves are 90%.) Thus, if you are a customer at the Mulligan bank, you can be certain that your notes are convertible in gold, if you should need or want actual gold. You cannot be that certain as a customer at the Lawson bank; usually you are on the safe side; but should it happen that many customers want to convert their notes in gold at the same time, there will be trouble.
The bank notes would, of course, have the name of the respective banks printed on them. But the denomination would be the same: there would be 1 rand notes, 10 rand notes, perhaps also 50 and 100 rand notes in circulation issued by those two banks. But the fact of the matter is that the Lawson bank 10 rand note is only worth 9 rand, although it says it’s worth 10 rand.
Now, suppose the public accepts the Lawson bank notes at face value. Under normal circumstances, that would not be unreasonable, because with a 90% reserve, the likelihood of a bank run is not that big.
Let’s see what happens to the purchasing power of the money under those circumstances. Let’s assume that each of the banks has 1 million ounces of gold in their vaults; thus, the total amount of gold money circulating in the economy is 2 million ounces of gold, or 2 million rand.
But now the Lawson bank issues notes to the amount, not of 1 million, but of 1.1 million rand; thus, the total amount of circulating money becomes 2.1 million rand, not just 2 million. And the result of that will be rising prices. We will have inflation. Not much inflation, but inflation nonetheless.
Now, one could change the figures here and assume the Lawson bank has only 80% reserves. That would mean more inflation. One could assume that it has only 10 or 5% reserves, and there will be a real big inflation. However, in this example, I think it would be impossible for the Lawson bank to have such low reserves, because that would simply destroy the public’s confidence in the bank, there will certainly be a bank run and the Lawson bank would go bankrupt. (Remember there is no central bank to bail it out.)
But why would the Lawson bank want to be on a fractional reserve system in the first place? Well, a bank’s business, if it is not just to be a storage place for its customers’ gold, is to lend out money and charge interest on these loans. And in the scenario I have sketched here, the Lawson bank has more money to lend out than the Mulligan bank; by having 90% reserves instead of 100%, they gain a competitive advantage over the Mulligan bank. Being able to advance more loans, they earn more in interest than the Mulligan bank.
This may lead to the Lawson bank being tempted to lower their reserve ratio even more: to 85%, then to 80%, etc. But sooner or later a point will be reached, where the public’s confidence in the bank will be severely shattered, so this is a risky undertaking. Also, the Mulligan bank may be tempted to follow in the Lawson bank’s footsteps and lower its reserve requirements.
What about the borrowers? For a bank to lend out money, it would have to lend the money to productive enterprises, so that it will in time get its money back plus interest. The borrower will invest the loan in such things as raw materials, machines, new factories, employing more workers.
And just as the Lawson bank gains a competitive advantage over the Mulligan bank, the customers of the Lawson bank gains a competitive advantage over the customers of the Mulligan bank. They have more money to invest.
Now, it should be known from Mises’ writings that the recipients of new money, or new fiduciary media, are in a position to buy before prices have risen, while others are in the position of having to buy after prices have risen. Now, the Lawson bank’s policy of issuing fiduciary media has this effect of making prices rise. But a person who borrows from the Lawson bank is in a position to buy his raw materials, his machines, the materials needed to build a new factory, to employ his new workers before the prices of these factors have risen. The rest of us will pay him in the form of rising prices later in this cycle. This is why I regard inflation – even the mild inflation of this example – as fraud.
If both banks were on a 100% reserve standard, prices would not rise. (Except insofar as no new gold is being mined and coined, but this is a different matter.)
Of course, this is a thought experiment, and I have simplified matters . In real life we are not likely to encounter a situation with only two competing banks. But the principle will not change, if there are a variety of banks, some of them operating on a 100% reserve standard, others on varying fractional standards.
Of course, in today’s society, we are not likely to encounter free banking and no government intervention in the economy, which makes this reasoning slightly utopian.
However, I think I have made my main points: 1, that the issuing of fiduciary media (or “fractional reserve banking) is inflationary even when performed by private banks; and 2. That the practice is fraudulent, insofar that some people stand to gain from it and others stand to lose; and this not because of any objective superiority of the first class of people over the second.
I don’t think I will convince any adversary by this reasoning; but at least I have tried.
What do other economists have to say about this issue? We know both Rothbard and Reisman favored outlawing fiduciary media. But what about Ludwig von Mises, who after all pioneered this subject ? Well, there is on quote from The Theory of Money and Credit that might shed light:
[T]he only way of eliminating human influence on the credit system is to suppress all further issue of fiduciary media. (P. 447.)
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