In a paper posted at the Ludwig von Mises Institute Canada site, James E. Miller offers a critique of a piece written by John Tamny of Forbes, in which Tamny addresses the subject of money creation through fractional reserve banking.
I have written often on this subject, most recently here. I may be somewhat repetitive today, however Miller offers me the opportunity to perhaps expand or otherwise further clarify my views.
I will begin where Miller ends:
In ancient times, the penalty imposed on bankers for lending out money held strictly as demand deposits would vary from being forced onto a diet of bread and water to public beheading. Though these punishments were extreme, they show just how unethical fractional reserve banking used to be seen as.
The practice of banking today is not what it was in ancient times. In ancient times, where demand deposits actually existed, such punishments might have been warranted. Demand deposits in the traditional sense do not exist today – certainly not by contract, and not by applying logic to understanding the depositor / bank relationship.
Not only does fractional reserve banking play a crucial role in inflationary credit expansion, it borders on being outright fraudulent.
It may be fraudulent if the depositor has a contract that the assets deposited are being held, solely for withdrawal and use at the depositor’s discretion. While I have no doubt such contracts were available in the past, such is not the nature of deposit contracts today. I refer again to Regulation CC, controlling availability of deposits. I will not expand on this here, as I have done so in my above-mentioned post.
What are called demand deposits today are not demand deposits in the classical sense. These funds are not stored in a separate vault available only to the depositor. The digital form of the funds is not held in a non-networked computer. If such were the case, two things would be certain: 1) the depositor would pay a storage fee, and 2) the depositor could not earn interest. Alas, many “demand deposit” accounts are available today without any storage fee and with interest being earned. Logical business practice would render this as not being an option.
More so, it is quite clear when reviewing the exceptions regarding availability of deposited funds (in regulation CC), that having such exceptions suggests that the funds are not held solely for the depositor’s benefit – else why have the exception?
I know of only one way to have a true demand deposit account in today’s banking system – and that is to avoid today’s banking system: remove cash from the bank, store it in a safe or vault. Retrieve the cash as needed. Other than this, there is no possibility that I can come up with to have a valid demand deposit account today.
So what exactly is ethically wrong with fractional reserve banking? In his book Money, Bank Credit and Economic Cycles economist Jesus Huerta de Soto explains that the clear distinction between what would be considered demand deposits and savings available for loans has been enforced in banking history dating all the way back to ancient Greece.
Demand deposits were considered those deposits which banking customers believe they have direct access to at any time….Deposits which were used to lend to entrepreneurs for a fixed amount of time were understood to be off limits by the patrons who provided them. Typically the saver who placed his money in a bank for a specified period of time would do so to profit from a predetermined rate of interest. Under this system of strict separation between demand deposits and deposits used for lending, a duration mismatch, or a bank not having enough money on hand to pay all demand deposits, will not occur.
I have only begun reading this book by de Soto, so I cannot comment on it as of yet (who knows how many words I might eat....?). I am certain that it was possible in times past to hold assets in storage, available for the depositor to retrieve on demand. Suffice it to say, the applicability of ancient Greek practice to what is today referred to as “demand deposits” is lost on me. One is certainly free to open a vault service to hold cash as I have described above.
In the case of fractional reserve banking, if depositors were to agree that their money was to be used for additional lending, there would be no issue.
But this is precisely what depositors today are agreeing to – so there is no issue. The regulations make clear that there are possible exceptions to funds being available. The paying of interest and lack of charges for storage also makes this clear. In the case of dissolution of a bank, the senior creditors have first claim on the deposits – shown as a liability on the banks’ balance sheet. Why are the deposits even on the bank’s balance sheet if they are strictly being held for the benefit of the depositor? Why aren’t deposits shown only on a subsidiary ledger, completely segregated in all ways form the bank’s balance sheet?
But usually depositors don’t fully realize that their funds are not really there in whole. In a recent study commissioned by The Cobden Center, it was found that 74% of U.K. residents polled believed they were the legal owners of their banking deposits. And while 61% answered that they wouldn’t mind if their money was used for additional lending, 67% responded that they wanted convenient access to what they saw as their money. Whether or not one regards fractional reserve banking as a clear case of fraud, it seems that a good portion of the public is wrongly informed on the mechanics of modern day banking.
“A good portion of the public is wrongly informed” on many things in life. This cannot be characterized as fraud. That a depositor signs a contract with one set of terms yet somehow believes the relationship is defined by another set of terms might be described as many things, but fraud is not the first term that comes to my mind.
Besides standing on shaky ethical grounds, what is problematic with fractional reserve banking in practice? As the Austrian Business Cycle Theory stipulates, credit expansion distorts relative prices and economic calculation to the point where entrepreneurs see long term investment projects as profitable.
I will agree that the ethical grounds of modern banking are shaky, but not for the reasons Miller suggests. Additionally, there are problems with credit expansion, and the Austrians have provided the best exposition and explanation of these problems and consequences.
To see how credit, or what is also called fiduciary media, expansion can and does become pyramided through fractional reserve lending, it helps to consult Murray Rothbard’s textbook on banking “The Mystery of Banking.”
Miller then walks through Rothbard’s examples of the compounding nature of holding fractional reserves. This entire issue is a side show to me – it is a distraction from the real issue. Mises, Sennholz, and I can now add Ballvé, (as three examples) do not focus on the issue in the manner many Austrians focus on it today – I will come shortly to comments by Mises directly on this subject. As I have previously written, the paramount issue is monopoly banking, protected and insured by the government.
…just as people pay storage unit owners to safeguard their possessions, some may pay for warehousing of their money as history has shown. If some individuals in turn wish to be paid interest for their deposits, they may sign over their funds for a specific period of time and interest for the bank to lend it out at a higher rate.
But this is exactly the point. Individuals ARE collecting interest on these so-called demand deposits. How is this possible? Individuals are NOT paying storage fees. Is it because of the goodwill of the banks that these arrangements are available? Of course not. The funds have been turned over to the bank to then loan out in order to earn a return such that the depositor can avoid a fee and also earn interest. This is the contractual nature of the deposit, and it is the only business practice that can make sense given these conditions.
In the end, Tamny thankfully realizes that the backstop provided by the Federal Reserve and government deposit insurance provides the perfect mix of incentives for banks to engage in risky lending. Abolishing both would be a great first step in achieving sounder money and a healthier banking system. It is unfortunate that he doesn’t hold the same to be true of fractional reserve banking.
I have not read the Tamny article. But based on this summary, Tamny is right, and is pointing to the root of the problem – and in fact the only problem Austrians should hammer away on. “Abolishing both” would not only be “a great first step,” but in fact the most critical – and ultimately only necessary – step. Why the monopoly? Why the government protection? Remove these, and the concern about fractional reserves being a systemically destabilizing force will disappear. Note: I do not say fractional reserve banking (or more specifically, excess credit creation) will disappear….
As Ludwig von Mises, whom Tamny quotes frequently in his work, wrote:
It would be a mistake to assume that the modern organization of exchange is bound to continue to exist. It carries within itself the germ of its own destruction; the development of fiduciary media must necessarily lead to its breakdown.… It will be a task for the future to erect safeguards against the inflationary misuse of the monetary system by the government and against the extension of the circulation of fiduciary media by the banks.
This quote is from The Theory of Money and Credit. If Miller is going to quote Mises, perhaps he can additionally look to his further work in Human Action, and Mises' approach to free banking (From Human Action, Chapter 17, Section 12) where Mises seems to have taken himself up his own challenge “for the future to erect safeguards against the inflationary misuse of the monetary system by the government and against the extension of the circulation of fiduciary media by the banks”:
But now, we assume further, one bank alone embarks upon an additional issue of fiduciary media while the other banks do not follow suit. The clients of the expanding bank - whether its old clients or new ones acquired on account of the expansion - receive additional credits, they expand their business activities, they appear on the market with an additional demand for goods and services, they bid up prices….In order to settle the payments due to non-clients, the clients must first exchange the money-substitutes issued by their own - viz., the expanding bank-against money. The expanding bank must redeem its banknotes and pay out its deposits….The instant approaches in which the bank will - after the exhaustion of its money reserve - no longer be in a position to redeem the money substitutes still current. In order to avoid insolvency it must as soon as possible return to a policy of strengthening its money reserve. It must abandon its expansionist methods.
Mises does not rail on about banks expanding credit as being fraudulent. He offers that the market, if left free, will properly regulate the practice.
But even if the 100 per cent reserve plan were to be adopted on the basis of the unadulterated gold standard, it would not entirely remove the drawbacks inherent in every kind of government interference with banking. What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract.
Mises does not demand a 100 per cent reserve standard – only that banks remain subject to general commercial and civil laws – get the government out of the business of backstopping the banks.
Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular - one is tempted to say normal - feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.
Mises does not see laws as the means to eliminate the excessive creation of credit. He does not fear the “slow credit expansion” likely to be experienced under free banking. Rather, he sees the free market as being the best means to limit the damage that is caused by such practices.
This obsession with fractional reserves must end. The root of the problem is the monopoly and the government protection. As Dr. North points out, virtually all economists acknowledge the damage caused by government enforced monopoly, yet go blind when the subject is raised in regards to banking.
The monopoly is the root of the instability of the financial system. This is the root of inflation and the subsequent boom and bust cycle. Focus on the monopoly, and stop supporting the distraction by hammering on fractional reserves.