Thursday, August 21, 2014

Austrian View of Fractional Reserve Banking: Tamny Mostly Right, Shedlock Mostly Wrong

Update: Please read comments in this related post, as I often learn that I am still learning.

Update 2: See here.

One day most Austrian economists will decide that free markets, sufficient to provide and regulate the production of all other goods, will be sufficient to provide and regulate the production of money and credit.

One day most Austrian economists will decide that a contract is a contract.

One day most Austrian economists will understand that it isn’t fraud if one acts according to an agreement.   

One day most Austrian economists will understand that lending out (at a prudent – meaning market-derived and reinforced – reserve rate) deposits subject to immediate withdrawal has no greater distortive effect to the economy or prices as lending out against a time deposit.

One day most Austrian economists will conclude that the enemy is the monopoly, not fractional reserve banking.

Today is not that day.

John Tamny recently wrote a post at Forbes, “The Closing Of The Austrian School's Economic Mind.”  In reply, Mike Shedlock responded with “Idiot's Guide to Austrian Economics.”  The subject is fractional reserve banking.  These two commentaries deserve some examination. 

NB: Both Tamny and Shedlock broadly generalize and apply their criticisms and defenses to the entire Austrian school.  On the subject of fractional reserve banking, there is significant disagreement within this school.  Neither author states this important point. 

With this, let’s begin.
Tamny: …the thought processes that inform the modern “Austrian School” more and more read as statist, monetarist in their conceit about what’s allegedly the proper supply of money and credit, and probably most offensive of all, the reasoning at times reads as Keynesian.

Tamny levels three charges here:
1)      Austrian thought processes regarding money and credit are statist: I have often commented that it would take government action to prevent a depositor and banker from consummating a deposit contract along the lines of today’s bank deposit contract – the target of FRB critics.
2)      Conceit about the proper supply of money and credit: who is to say what the market might accept as backing for currency, or the appropriate reserves for banking, or the proper amount of credit?  Yet proponents of 100% gold-backed money and credit are saying.
3)      Keynesian reasoning: I look forward to reading Tamny’s charge on this.

Suffice it to say – at least on two of the three points – Tamny is correct (to the extent certain Austrian school economists hold such views).  Tamny goes into detail on each of the three:

Tamny: [banks] borrow money from depositors seeking a return on their savings, and who don’t need access to their savings right away, only to lend the money borrowed to individuals who do need it right away. The profits come from borrowing at one rate of interest, then lending longer term at a higher rate. To many Austrians, this non-coerced act of exchange between consenting individuals is a fraud, and needs to be treated as such by the state. The Austrians want government to restrain what they deem a violation of property rights.

Tamny gets to what I believe is one of the major stumbling blocks for many in this conversation.  It is only fraud if the bank contracts to do one thing yet does another – to the disadvantage of the counterparty.  Fractional reserve banking – as in the bank promises to warehouse your deposit, charges you for the service, but lends it out instead – does not exist in today’s banking contract.

Tamny: But what the Austrians who decry fractional banking seem to miss is that no well-run business ever implodes due to lack of money, and this includes banks. With the latter in mind, well-run banks making quality loans arguably need the smallest of cash cushions.

Tamny gets to the heart of the point made by both Mises and Rothbard – the market will regulate the lending practices of banks just fine.  If the loans are good and reserve requirements are prudently calculated (and certainly if cross-banking backstops are developed in the market), a bank will not run out of money.  No, this most definitely is not an excuse for fraud – there is no fraud; read the contract.

Tamny: To Austrians, fractional banking leads to “excess credit creation” through what they refer to as a “money multiplier.”

The problem is that the very notion of a “money multiplier” is a logical impossibility; one that dies of its illogic rather quickly if analyzed in the lightest of ways. To explain what isn’t, banks are generally required to keep a 10% deposit cushion. Simplified, if a bank is the recipient of a $1,000 deposit, it can generally only lend out $900, or 90% of its deposits. What might surprise some is that the previously described loan is what has many Austrians up in arms.

Please read the preceding again.  $1000 doesn’t become $10,000.  In fact, on prudently calculated reserves, $1000 doesn’t become more than $1000 in any economically meaningful sense.  The bank is confident in lending out $900 because it believes the depositor will not demand more than $100 from his deposit.  If the bank calculates wrongly, and both the depositor and the subsequent borrower withdraw the full $1900, the bank (and depositor) might have a problem.  The ability to withdraw on demand is conditioned in the contract.  Is bad business judgment a crime?

It is interesting: the two individuals – the initial depositor and the subsequent borrower – hold two accounts totaling $1900.  But digits on paper aren’t excess credit creation in any economically meaningful sense of the term.  If totally and simultaneously demanded, it would be excess (although this can’t be satisfied without a lender of next resort…hint) – but isn’t this applying hindsight to business judgment?

It isn’t fraud, and it isn’t excess credit creation.  In other words, an entrepreneur miscalculated the future – the bank manager calculated a wrong reserve ratio.  In every other business, we accept that the entrepreneur made a mistake – and may very well pay via insolvency.  Why not say the same for banking?

Tamny goes on to challenge the money multiplier further – the $1000 turned into $10,000:

Tamny: The obvious problem with the “money multiplier” theory, and to type it out is to arguably waste words, is that for one individual to attain access to $1,000, someone else must give up that same access. Credit can’t be multiplied. Period. For every individual who attains credit successfully, there must be a saver willing to give up near-term access to the economy’s resources.

The depositor has given up access to funds, and this is made tangible via the bank’s calculation of a reserve ratio; the bank estimates (via statistics and modeling) that the initial depositor will not demand more than $100 of his deposit.

Tamny: And to understand why the actual fraud is the strain of Austrian thinking that says fractional banking should be outlawed, readers need only consider NetJets and other transportation companies that frequently offer their customers unlimited private jet transportation, but at a fraction of the cost of an actual private jet. NetJets and their competitors have made the same calculations that banks have: just as savers generally won’t require access to all of their cash at once, so won’t fractional buyers of private flight transportation need or want to fly all the time.

I suspect the contract of fractional jet ownership has many caveats about jet availability just as today’s bank deposit contract has caveats regarding fund availability; I further suspect the fractional jet contract does not state that a plane will be held at your local airport 24/7 just in case you might demand it, just as today’s deposit contract does not state that your funds will be held – allocated and segregated – 24/7 just in case you might demand it.

Tamny: The oddity is that historically market-friendly Austrians would want the state to have a role in abolishing fraud that, if it actually existed, would quickly be erased by market forces as is.

This is equally strange – even bordering on appalling – to me.  To begin, fraud is a gray concept – where does make-up advertising fit in?  The latest diet miracle?  Leave it to the market, as Tamny (and Rothbard and Mises) suggests.

Tamny: Instead, some seemingly seek mandates; their solution being “deposit banks” with “100 percent reserves.”

Mises and Rothbard both find the market to be an effective regulator of money and credit – why introduce a third-party actor to regulate that which the market can regulate effectively?  Others like Ballvé and Sennholz don’t even raise a negative issue of FRB.

Tamny: Notable here is that no one is keeping “deposit banks” backed by 100 percent reserves from forming, thus raising the question why Austrians themselves don’t fulfill what they deem an essential market need.

I often wonder the same thing – where is the clamoring for true deposit banks?  Why aren’t people opening such institutions?  “Deposit your money with me, I will charge you one-percent per year for storage and pay no interest.”  To ask the question is to answer it.

Now Tamny gets to the “Keynesian” part:

Tamny: But since those with credit generally don’t want to pay others to sit on it, that’s why the “deposit banks” that some Austrians oddly claim essential to capitalism aren’t all the rage in finance. Of course if they were, Keynesians would love just such a bank. Deluded by the false belief that the act of saving amounts to hoarding (quite comically the mythical bank desired by Austrians is the one Keynesians laughably think exists) and a lack of consumption, if everyone was paying banks for the privilege of warehousing their cash, the depositors would quickly remove the cash from “deposit banks” to spend it to the delight of John Maynard Keynes’ disciples.

This is an interesting connection, and one that I had only partially made previously; I long ago discarded the notion of “cash sitting on the sidelines.”  The only way cash sits on the sideline is if it is held as currency in a mattress or vault or wallet.  I suspect excess reserves could also be considered the same.

But deposits in a bank are not sitting in the sideline – taking into account the reserve ratio.  These are lent out – there is no hoarding.  It is the connection to this Keynesian criticism that I had not made previously.

Tamny goes on to make other Keynesian comparisons, but these are beyond the scope of this post.

So much for Tamny, now on to Shedlock.  Mish cites certain passages from Tamny’s piece, and then offers a rebuttal.  Again, not all Austrian economists hold the views that Shedlock claims they hold.  With that out of the way…

Tamny: "It’s well known that some Austrians have a major problem with 'fractional reserve banking' whereby banks pay for liabilities (deposits) by virtue of turning those liabilities into assets (interest paying loans). Instead, they borrow money from depositors seeking a return on their savings, and who don’t need access to their savings right away, only to lend the money borrowed to individuals who do need it right away. The profits come from borrowing at one rate of interest, then lending longer term at a higher rate."

Mish: With that single paragraph Tamny proves he does not understand AE or fractional reserve lending. In fact, he makes it clear he is clueless as to where the money banks lend even come from. AE has no beef against lending. Rather, AE does object to money being created out of thin air for lending.

I don't care, nor does AE care if 100% of deposits are lent out, as long as three conditions are met: 1) Money is not created into existence by the loan 2) Money is not lent out for terms longer than the bank has access to the money 3) Depositors who lend money to the banks for interest are the ones who pay the price should there be a default on the loans.

Point 1: Money is not “created into existence” in any meaningful sense.  If reserve ratios are prudently calculated, the initial depositor will demand no more of his money than the bank has estimated.  Digits on his screen that aren’t spent (and this is the bank’s calculation) are not meaningful in any economic sense relevant to this criticism.

Point 2: Why not?  Is it Mish’s job to determine prudent business practices for banks?  Is Mish suggesting (as some Austrian economists do) that central planning works for the banking industry?

Point 3: So-called demand deposits pay interest.  Mish does not grasp the implication of this statement, it seems.

Tamny: "Banks aren’t in business, nor could they remain in business if they simply warehoused money."

Mish: Is there a need for warehousing? Even if the answer is no (which it isn't), Tamny clearly fails to understand AE does not preclude lending. AE only precludes fraudulent lending.

Define fraud in a precise and meaningful way.  Now apply this definition to today’s banking contract.  It can’t be done.

Tamny: To many Austrians, this non-coerced act of exchange between consenting individuals is a fraud, and needs to be treated as such by the state. The Austrians want government to restrain what they deem a violation of property rights.

Mish: No! The problem of property rights comes into play multiple ways. Let's go through some examples.

1. Banks take a deposit, say a CD that pays interest for 5 years. Then the bank lends the money for 30 years. That's as fraudulent as me leasing a home for 5 years and issuing a 15 year sublease on my lease.

Money (unlike a home) is fungible – no bank takes the specific proceeds from one CD and loans out the exact funds to a third party.  A bank – like every business – has a capital structure, with liabilities and equity on the right side supporting assets on the left.  Banks – like every business – make business judgments about the prudence of their balance sheet.  Those who make good judgments succeed; those who make poor judgments (should be allowed to) fail (hint: it’s the monopoly that’s the problem).

Mish: 2. Checking accounts are known in the industry as "demand deposit accounts". Money is supposed to be available on demand. It isn't. In 1994 Greenspan allowed sweeps, whereby banks can nightly "sweep" all money from checking accounts into savings accounts, unbeknown to the depositor, so the money could be lent out. Money people think is there for safekeeping isn't there at all. The Fed recently stopped reporting of sweeps

Sound fraudulent to you? It does to me.

The issue has nothing to do with Greenspan in 1994, but a court decision in England from about 150 years ago.  Further, what’s with the wishy-washy terms: “known in the industry,” “supposed to be,” “people think”?  What do these mean?  How about just reading the contract?  (I address the concept of “meeting of the minds” here.)

Wait, Mish doesn’t like contracts either:

Mish: It's fraudulent even if people agree to it in obscure hard to understand account legalize. Why? Because it's as fraudulent as lending out 100 tons of grain when only 20 tons are in the warehouse, whether or not the owner of the 20 tons of grain signs an OK for lending out 100 tons.

It is impossible to lend 100 tons when one only has 20 tons.  Why does Mish insist on introducing strawman arguments?

Look at a bank’s balance sheet – if Mish can demonstrate that assets do not equal liabilities plus equity I will pay some attention; until then, this is nonsensical.

Mish: 3. Fraudulent lending of money causes economic distortions of all sorts, especially economic bubbles and income inequality. Those with first access to money (the banks and the already wealthy) are the ones who benefit the most. By the time money is available to the lowest guys on the totem poles, assets are already grossly overpriced.

The one place that money-comes-from-nothing is the central bank – it is the only institution capable of drawing a check out of thin air.  Mish’s criticism is valid only against this monopolizing institution; he should spend his energies here.

Mish: Price and asset inflation caused by lending out more money that exists is tantamount to theft. It artificially and fraudulently lowers the value of money on deposit kept for safe-keeping (checking accounts).

“My neighbor sold his house for 20% below what it was worth.  He now ruined my sale.”  What nonsense.

I have a right to my property.  I have no right to the value of my property.  I still have the digits in my account and the currency in my wallet – these have not been stolen.  Mish, purporting to be an Austrian economist, apparently does not understand subjective value.  (please…this does not mean I agree with central banking)

Mish: Let's return once more to property rights.

If I give money to a bank and it promises my money will be available on demand, and the next moment it lends a large portion of it out, my property rights are clearly violated.

What happens in such instances is twofold.

1. I own my money.
2. Someone else owns my money too.

Logically that is impossible. And that is precisely why it's fraudulent. I challenge Tamny to dispute that simple math! (emphasis in original)

The math cannot be disputed – if you add the sums in the two passbooks, the total will be $1900. 

But the logic can be disputed – it is simpleton logic: once deposited, it is not “your” money in the sense Mish suggests.  The bank “promises,” with conditions.  Ownership can be conditioned by contract – and it is in the case of deposits in today’s banking system.

Certainly, if both depositors show up to claim the $1900 immediately, the bank will have a problem.  Does Mish suggest making poor business judgment illegal?

Mish Cites Rothbard:

Mish: On page 46 of the book Case Against The Fed Rothbard says "By the very nature of fractional reserve lending, banks cannot honor all its contracts".

Since that is known upfront, in advance, how is that not fraud?

Read the contract.  If banks were in violation of the contract there is the opportunity for a multi-billion dollar class-action lawsuit, right now, today.  Go for it, Mish – your cut of billions would be a few hundred million. 

If the banks are not in violation of the contract, all the talk of fraud must stop.  Fraud is a legal term; if it is not to be interpreted through the contract, it is a meaningless term.

In the meantime, it would be nice if Mish cited Rothbard on the ability of the market to regulate excess credit creation.  Advocates of Mish’s position always seem to forget that Rothbard wrote another chapter.

Mish isn’t totally blind – he runs full speed into the problem, yet it appears almost as an afterthought:

Mish: People are willing to go along because of deposit guarantees, and also because the state mandates fiat money as legal tender.

This is the problem.  End the monopoly; end the government guarantees.

End the Fed.


  1. "The profits come from borrowing at one rate of interest, then lending longer term at a higher rate."

    This, of course, is nonsense.A banks profits come largely due to the ability to create money cost free and lend it at a premium.
    It has nothing to do with their depositors funds costs.

  2. Much depends on the definition of fraud. If I offer a service or product that is dangerous to the consumer, and fail to ensure that the consumer is aware of the danger, is that fraud?

    By your implied definition, the answer is 'no' if the terms of a contract are upheld. In an alternate universe, a court might require of the vendor that he verify the consumer's understanding of the danger entailed by the product or service.

    Bailment accounts in precious metals do exist. I know of no bank, however, that offers bailment accounts in cash. I suspect the reasons are several. One is: the central banks "print" money at such a rate, one would ordinarily take a substantial loss over time in the value of one's deposit. The other reason may be regulatory.

    A safer system of lending would limit lending of money belonging to the shareholders of a bank. An individual could buy shares as an investment, or put his money into a bailment account.

    I agree, however, that in a laissez-faire system sans central banks and govt. interference, one shouldn't denounce fractional-reserve banking as fraudulent -- unless one's society adopts the more stringent definition of fraud.