Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Monday, September 19, 2011

Fractional reserve banking

Fractional reserve banking is sometimes portrayed as a sort of scam; a method by which rich bankers  underhandedly sap the wealth of society. This short video here, How Fractional Reserve Banking Increases Inflation and Steals our Wealth, is fairly representative of a view I hear expressed quite often.

As you might have guessed, I think that this view is somewhat distorted and misleading. Let me explain why I feel this way.

The video starts off with an hypothetical depositor who starts off with $1000 and asks what happens when it is deposited. Right away we are off to a poor start.

Does he mean starting off with $1000 of cash? Or does he mean $1000 of money (say, in the form of a paycheck)? It makes a difference. When was the last time you made a cash deposit? If you are like me, you cannot remember when. Of course, money gets "deposited" all the time in your account. At work, for example, you might be paid by check or by direct deposit. But this is not what the guy means by "making a deposit"--these "deposits" are simply debit and credit operations in a linked system of accounts (your paycheck is credited to your account, and is debited from your company's account). What the guy means by a "deposit" is a cash deposit. The main source of cash deposits in all likelihood originates from the cash registers of retail businesses.

Alright then, evidently there is cash in circulation. These days, cash primarily takes the form of small denomination paper notes issued by a central bank, like the Fed (in the past, cash frequently took the form of specie--gold and silver coin). There is a demand for cash. Cash is useful for purchasing some types of goods and services when no other means of payment is available. (Cash is also used when transactors wish to keep their exchanges anonymous). And so people occasionally visit ATMs to make cash withdrawals. This cash ultimately finds its way in the cash registers of businesses (however, it is estimated that a lot circulates in the underground economy and, in the case of the U.S., outside of the country).

O.K., so where does banking fit in all this? Maybe your ideal view of a bank is simply as a place to keep your cash safe, kind of like your piggy bank. You deposit your cash with the bank, and the bank issues you a receipt, which constitutes a record of your cash deposit and represents a claim for cash (deliverable by the bank). Or the bank may simply record your deposit as a book entry item. Either way, your cash deposit constitutes a liability for the bank. These liabilities are sometimes called "bank-money" because, well, because they can be used as money. Receipts (especially if they are made payable to the bearer) can potentially circulate as money. Similarly, checks can be written ordering the transfer of cash sitting at the bank from one account to another. If the value of liabilities issued by the bank do not exceed the amount of cash it holds as assets, then we call this 100% reserve banking. (The liabilities issued by the bank are backed 100% by cash.)

Of course, banks do not just keep your cash safe and perform debit/credit transactions for you. They also make money loans. And here is where the confusion generally begins. It starts with the idea that the bank might have the temerity to lend YOUR cash out to someone else--at interest, to boot!

Well, that's not quite what happens. Let try me explain (well, to the best of my understanding, of course).

Suppose you want to start a restaurant business. You own the property and building, but nothing else (apart from your human capital). The building needs to be made into a restaurant. You need ovens, utensils, rooms to be made and finished, furniture, staff, advertising, accountants, lawyers, etc. How do you pay for all this stuff? You clearly have wealth (physical and human capital). You just don't have any cash.

But what do you need cash for anyway? Why not pay for all this stuff using your wealth? One way to do this, in principle at least, is to issue receipts representing shares in your wealth. These shares are liabilities against your wealth. Each share represents an IOU against the future income stream generated by your capital. (The IOUs could take a variety of forms. They could, for example, be made into coupons redeemable for food from your restaurant--something very similar to Canadian Tire Money).

Um, one problem. If you're like me, not very many people know who you are. A randomly selected member of society is unlikely to recognize us, or have any idea what we really own, or have any idea how well we might live up to the promises (IOUs) we issue. Basically, most of us are anonymous (except for within a relatively small network of friends and business relations--and even then, we keep a lot of information private). Anonymity renders our capital illiquid (it is not easily or widely accepted as a means of payment).

O.K., so scratch the idea of creating your own money. This is where a bank now comes in. Let's imagine that the bank reviews your business proposal and concludes that it is likely to be profitable. The bank also thinks that your capital is of high quality and that your ownership title is clear (btw, you are now no longer anonymous to the bank). Now, you might think that the bank is then going to lend you the cash you need to finance your operations. Well, you would be wrong (sort of). That is, you do not need cash--what you want is bank-money. And that's what you typically get from the bank: a money loan in the form of bank liabilities (not cash).

Now, the commentator in that video claims that this bank-money is created out of thin air. That is both correct and completely irrelevant; see my earlier post here. The bank-money (whether in the form of paper notes or book-entry objects) are backed by the assets you put up as collateral for your loan. As long as the loans officer makes good decisions about which business ventures to lend money to, the bank-money created by the bank is fully backed (and consequently, not inflationary; i.e., the new money issue is not dilutive). What the bank has in effect done here is transform your illiquid capital into a liquid liability. This is hardly an activity that one might reasonably label as being inherently "evil."

But this is not quite the end of the story. I have just made the claim that banks issue fully-backed liabilities that serve as money instruments. If this is true, then what do people mean by fractional reserve banking? Let me explain.

In practice, banks issue a very peculiar type of liability, called a demand-deposit liability. In the lingo of financial wonks, these are liabilities that have embedded within them a contractual stipulation known as an American put option. This option gives the debt holder (the depositor) the right to exercise a redemption option on demand at a fixed price. The redemption option in this case consists of the right to redeem bank-money for cash on demand (and usually at par, but frequently subject to a service charge). This is what happens every time you make a withdrawal of cash from your bank or an ATM.

Why do banks do this? Isn't is a recipe for potential trouble?

I don't know why banks do this. In many jurisdictions, it may constitute a legal restriction (as part of the bank charter). I'm not sure if the restriction is binding, however. That is, it is my understanding that banks used to do this even when they were not legally required to do so. Evidently, the redemption option is valued by those who make use of bank-money.

I am aware of only two (not necessarily mutually exclusive) explanations for this contractual stipulation. One is that consumers value insurance against "liquidity shocks" (events were only cash is accepted). The other is that the redemption option serves as sort of a discipline device for bank managers (see Calomaris and Kahn, AER 1991). That is, the put option makes the bank's liability a very short-term debt instrument, so that depositors can potentially pull out very quickly if they sense any hanky-panky. The threat of mass redemptions (and the bankruptcy it would entail) is presumably enough to dissuade self-interested bankers from absconding with depositor wealth.

Sounds wonderful except that, of course, only a very small fraction of a bank's assets are typically in the form of cash. Most of the bank's assets are tied up in "long-term illiquid" assets, like your house, or your human capital. Consequently, while the bank's liabilities may be fully backed, only a small part of this backing is in the form of cash. This is the true nature of fractional reserve banking.

The potential trouble, of course, comes to play when a bank (or worse, the banking system as a whole) is subject to a wave of mass redemptions. There is simply not enough cash in the banking system to honor all of its short-term debt obligations simultaneously. (This is not fraud or deceit; it is something that everyone is--or should be--plainly aware of.) In this event, banks are compelled to sell off their assets to raise the cash they need. This is not something that all banks can all accomplish simultaneously; at least, not without depressing asset values and creating a deflation (the fall in the price-level reflects an increase in the demand for, hence value of, cash relative to goods and services).

There are basically two (possibly more, as readers have suggested below) ways to eliminate retail-level banking panics (waves of mass redemptions). Neither are without cost. One way is to adopt some sort of national deposit insurance system. This is the system that presently exists in the United States (FDIC plus the Fed discount window). People criticize this system because it allegedly promotes moral hazard (banks are induced to take on excessively risky investments). On the other hand, the U.S. has not experienced a retail-level bank run since the Great Depression.

The other way to eliminate retail-level banking panics is to pass legislation requiring all banks to hold 100% cash reserves. This would, of course, kill the business that transforms your illiquid assets into a liquid payment instruments. But it would not necessarily kill the prospect of bank-run-like phenomena. This is because bank-run-like phenomena can emerge even without fractional reserve banking. The phenomenon is possible whenever short-term debt is used to financed long-term (illiquid) asset purchases, as is the case in the wholesale-level banking sector (the so-called "shadow banking" sector).

The use of short-term debt to finance long-term asset purchases (think of the overnight repo market) is, again, a very peculiar financing structure. Like the demand deposit liability, the structure is likely explained by the need to align incentives. While this structure may enhance efficiency along some dimension, it comes at a cost. The analog to a bank run here is a "roll over freeze." This is an event where creditors (depositors) refuse to rollover their short-term funding en masse. In this event, debtors must now scramble to raise funds or dispose of their assets (at "firesale" prices).

If this sounds familiar, it should: it is exactly what happened in our most recent financial crisis. It is also what policymakers currently fear might happen to European banks (who have borrowed USD short-term, to finance longer-term asset purchases; see here). 

107 comments:

  1. Nice and clear.
    Thanks!

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  2. Thanks for this. Indeed the hyperbole surrounding the "magic of money" and "money is debt" and all this does a disservice to meaningful discussion and understanding of how the banking system works. Discussions by you and worthwhile of late are pointing things in the right direction.

    But never let the facts get in the way of a great conspiracy!

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  3. David:

    I've always thought of a checking account dollar as a call option on a paper dollar, with a strike of 0 and no expiration. I guess you could call it a put, but option theory is mostly written around calls, so that seems easier.

    The option analogy also makes it clear that when Merrill Lynch issues a call on GM, the call does not dilute the value of GM stock. In the same way, a private bank that issues calls on paper dollars does not dilute the value of the paper dollars. Thus fractional reserve banking is not inflationary.

    Suppose some bank starts with $100 in paper money, against which is issues 100 checking account dollars, and then that bank lends 900 checking account dollars to a borrower who offers a $1000 house as collateral. If that house falls in value to $800, the bank is in trouble. But there are more than two ways to deal with that trouble. The bank can liquidate, and each checking account dollar-holder gets $.90 of paper, or the bank can suspend convertibility of its checking account dollars into paper dollars. Speculators will see that the bank has $900 of stuff backing 1000 checking account dollars, so checking account dollars will trade on the street for $.90 in paper. Either way, the bank's depositors lose 10%. Having an FDIC only shifts that loss to taxpayers.

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  4. Mike, according to Wikipedia:

    A put or put option is a contract between two parties to exchange an asset, the underlying, for a specified amount of cash, the strike, by a predetermined future date, the expiry or maturity. One party, the buyer of the put, has the right, but not an obligation, to sell the asset at the strike price by the future date, while the other party, the seller, has the obligation to buy the asset at the strike price if the buyer exercises the option.

    So I think of the depositor as the buyer of the put, who has a right to "sell" the asset (back to the bank) for cash. But I can also see why one might label this a call option. But labels really do not matter so much.

    I like your second paragraph very much. Thank you! I will use it in class.

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  5. David:

    Well, calling the checking account dollar a put makes the checking account dollar both the put and the underlier. If a checking account dollar is a call, then the paper dollar is the underlier.

    Actually, if a piece of paper promises delivery of a share of GM for 0, with no expiry, that piece of paper is usually called a hypothecated share. The dilution argument is the same. Merrill's issuance of a hypothecated share of GM does not dilute GM shares, and a private bank's issuance of hypothecated dollars does not dilute the central bank's dollars.

    You're welcome. I guess you won't take the bait on bank runs.

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  6. Mike, I think I will defer to you on this matter! I am no expert in finance. Hey, I must have missed the bait you were offering. I saw nothing to disagree with in your last paragraph, and I saw no explicit question being posed.

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  7. David,

    Tempting the Rothbardians again I see.

    I have no disagreements; in fact, you only write facts! Quick question, though. You say: "There are basically two ways to eliminate retail-level banking panics (waves of mass redemptions)." Then you name FDIC-Fed, or 100% fractional reserve banking.

    What about a free banking? Isn't the inherent competition of such a system going to go a long way in reducing (even eliminating) mass bank panics?

    I can see the adverts now: "We hold 20% in reserve, not 10% like the other guys!"

    or "Our capital cushion is like a Sealy Posturepedic it's so supportive!"

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  8. Prof J:

    I would be very curious to know how a "Rothbardian" might reply to this post, so if you know of any, please ask them to read and comment.

    No, I do not think that free-banking would eliminate panics. There is a social cost-benefit calculation that needs to be made here. It is possible that structures that eliminate the possibility of redemption waves might be socially suboptimal. (Whether free-banking might get us closer to the optimal risk level is another question.)

    Isn't the repo market largely an exercise in free-banking? Competition seems to deliver the outcome of short-term financing for long-term debt. This seems to be an equilibrium outcome. It is an outcome that exposes the system to rollover freezes.

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  9. David:

    I was arguing against your proposition that there are two ways to handle bank panics: FDIC insurance and 100% reserves. The two other ways are (1) liquidate the bank, paying $.90 on the dollar, or (2) suspend convertibility, and watch the bank's dollars fall to $.90 each. Either way, depositors lose 10%. This doesn't seem very scary, especially to a guy like me who just watched the value of his house fall by 40% since 2006. It would hardly bother me at all if the $4000 in my checking account fell by 10%.

    Compared to this, the other options look much worse. (1) In a true bank run, the first 900 people in line get either $1 cash or else $1 in bank assets, while the last 100 people get nothing. And the town's money supply drops from $1000 to $100, which seems really bad for trade. (2) In an FDIC bailout, the 10% loss falls on taxpayers, where it clearly doesn't belong. That's bad, but not as bad as a bank run. (3) In 100% reserves, banks are restrained from lending in the first place---also pretty bad.

    I argue with Rothbardians over at Mises.org all the time, and their opinion can be summed up as "Fractional reserve banks are counterfeiters. The central bank is the head counterfeiter."

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  10. @David, I think what you're describing is the mechanics of the transactions, however I think there is something more, namely that the bank cannot lend out money it doesn't have, the intricacies have more to do with making transactions fluidly instead of accounting for the spot amount of cash. This is all settled at day's end using interbank lending to get the ratios right. If I suddenly move my balance from JPM to to C, C will turn around and lend out my balance ASAP. The interim paper you describe is for ease of transactions.

    I think it is a put option. I have the right to retrieve a defined amount of cash. The bank has the obligation to produce this defined amount of cash. Right, obligation, both required to make the trade.

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  11. "There are basically two ways to eliminate retail-level banking panics"

    How about the discount window? This is for the rare situation where all banks get runs at the same time.

    The panic of 2008 wasn't the lack of cash, it was that bank A didn't want to lend to Bank B because A didn't think B would be able to pay them back in full with interest the next day. Correcting that was more than providing LoLR functionality, it was restoring interbank confidence, and it turned out that could only come through mass recapitalization.

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  12. Good post David. I'm going to advance one argument against fractional reserve banking. I'm not sure I fully believe this argument. It is not watertight. But there might be something to it.

    If I sell copies of a piece of music, or film, or writing, even if I clearly mark them as copies, I am taking someone else's intellectual property.

    It seems to me that if I issue my own money, redeemable at par in your money, I am doing something similar. You invested in building up a brand name for your money, getting people to trust its value, and getting it widely accepted and used as a medium of exchange. And now I am issuing a close substitute and so will take away some of your seigniorage rents. You must withdraw from circulation an equivalent amount of your money, in order to preserve the value of your money (and mine too). So I get some of the rents you could have earned from your reputation, and yet you have the sole responsibility of ensuring that both our monies retain a stable value.

    It's perhaps a bit different when you are the state. But I think the force of the argument is stronger if you are a private issuer of money, and I gain from your investment in reputation, at your expense.

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  13. @Mike:

    Well, yes, I suppose there are more than two ways to eliminate retail-level bank runs. But I meant ways that do not entail haircuts. (I am assuming here, as in Diamond-Dybvig, that a bank-run is driven by a self-fulfilling belief; and not owing to a change in the fundamental value of the bank's assets.) In the DD model, the policy you suggest, namely suspending convertibility, also does the job. (In reality, however, suspensions are associated with disruption in trades, as in the National Banking Era banking panics, for example).

    One has to think carefully about any policy that transforms debt-like instruments into equity-like instruments in a crisis. After all, the debt structure must be playing some role. It might be critical, say from the perspective of ensuring ex ante efficiency, that debt covenants not be violated (ex post, via haircuts or dilution). I'm not sure I know the answer here, but appreciate your thoughts on the matter and will think about it.

    @Jesse:

    Yes, I did mention the discount window, did I not?

    And according to the accounts I have read (e.g., Gary Gorton), our most recent financial crisis was centered in the repo market--the shadow banking sector. I never claimed that there was a lack of cash; there was a lack of short-term financing according to historical norms. In particular, creditor were heavily discounting all sorts of ABS. This was associated with a "flight to Treasury debt." Etc. etc.

    Hey! You agree with me that it's a put option...lol. I'm not sure really.

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  14. Thanks Nick; it means a lot coming from a master-blogger like yourself!

    Well, let's go through your argument then.

    If I sell copies of a piece of music, or film, or writing, even if I clearly mark them as copies, I am taking someone else's intellectual property.

    Agreed.

    It seems to me that if I issue my own money, redeemable at par in your money, I am doing something similar.

    I don't see it yet; but then, "similar" is not the same as "same."

    You invested in building up a brand name for your money, getting people to trust its value, and getting it widely accepted and used as a medium of exchange. And now I am issuing a close substitute and so will take away some of your seigniorage rents.

    Whether the object I issue turns out to be a close substitute will depend on more than me just making a promise to redeem at par and on demand. It will depend on my credibility to do so. And if I am able to do so, I will take away some of your business for sure. But that is the nature of competition. (And I would not call the income generated by the operation as seigniorage, which I equate to inflation or share dilution).

    You must withdraw from circulation an equivalent amount of your money, in order to preserve the value of your money (and mine too).

    Not following. If a company issues new shares that compete with the shares of an existing enterprise, why should any share value be diluted? What matters is if the share issue is backed by a positive NPV project.

    So I get some of the rents you could have earned from your reputation, and yet you have the sole responsibility of ensuring that both our monies retain a stable value.

    I'm afraid I really do not follow (which does not mean you are wrong!) Are you thinking of competing banks issuing fiat money instruments, where reputations (not to over-issue) is what restricts supply? And that there is an incentive to free-ride on the reputation of others by embedding your fiat money with an option to be converted into another money? Hmm...

    By the way, the convertibility option might be replaced with a market. That is, what if there is no convertibility option; instead, if I want cash, I go and dispose of my bank market on a competitive spot market, on demand, so to speak (but I guess not at par--would be whatever the market dictates). Still--very close substitutes (only quibbling now about the exchange rate).

    Are you presently dating a Rothbardian? ;)

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  15. Nick and David:

    A possibly useful analogy to Nick's brand name/copying proposition: GM issues shares of stock. Merrill Lynch issues bits of paper that constitute a claim to a genuine share (calls on GM, warrants, hypothecated shares, or some other sort of derivative). I've never heard of a corporation objecting to the issuance of these derivatives. In fact they usually are glad to see it. So by analogy the central bank wouldn't object to the issuance of derivative moneys by private banks. Like stock, it's hard to find cases of a central bank objecting to the issuance of derivative moneys.

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  16. David:

    The point I should have emphasized is that if a bank is liquidated, or convertibility suspended, then that causes a lot less trouble than a full-on run. Liquidation or suspension means all depositors lose 10% of their deposit, which might not be a big deal. But the full bank run means the money supply drops from $1000 to $100, which is a big deal. So we shouldn't be worrying about how to avoid haircuts. We should be worried about avoiding huge drops in the money supply.

    One of the most prominent examples of the advantages of suspending convertibility is the Bank of England’s suspension on February 26, 1797. “Looking back from the safety of 1798, ‘A Proprietor of Bank Stock’ thus summarized the transition: ‘In this desponding state, when all men dreaded, with the utmost anxiety, the event that was seen to be inevitable, and not far distant, and which it was supposed would involve the kingdom in general bankruptcy and intire ruin, the 26th February, 1797, was the crisis that gave the happy turn, and almost instantly dismissed all the horrors and fears that surrounded us; restored complete confidence…’” (Horsefield, 1944, quoted in Ashton and Sayers, 1953, p. 19).

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  17. Mike,

    So tell me what happened. Did the BoE resume convertibility a short time later? Where their notes discounted in an orderly fashion? Were there trade disruptions? (The quote suggests not, or less than expected.)

    My favorite example is drawn from the U.S. National Banking Era, where convertibility into specie was suspended and substituting for convertibility into clearinghouse certificates.

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  18. Edward says:

    David, wonderful post!

    Beware! Rothbardian Argument Below

    I go to my local bank with $10,000 cash (specie). I am going to deposit it, but first I must make some choices. How much of my cash do I want “on demand” and how much of it am I willing to turn over to the bank to loan out and for how long? A key component of Austrian Business Cycle Theory is that the market interest rate for certain time periods must be a real reflection of the people’s demand for cash.

    So, I choose to deposit $1,000 in a checking (on demand) account, another $2,000 I put in a savings (30 day time deposit) account, $3,500 in a 5 year CD and 3,500 in a ten year CD. The longer term time deposits yield me higher interest.

    From a legal perspective, the bank may not loan out any of my checking account funds and may only engage in loans consistent with their depositors’ time preferences. So…if no one is willing to purchase a 30 year time deposit, the bank is not allowed to make 30 year loans.

    This set up, in theory, would deal with bank runs.

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  19. Interesting discussion. But hair cutting depositors did not work in UK during the last crisis, and most agree now that deposit insurance should not include co-insurance elements, for that reason. Bank holidays might work, ref. FDR in 1932 or 33, but then again for how long can you let people be without money. The just released Vicker's report in the UK tries to tackle this dilemma by making the retail part of banking more secure (i.e. by making sure that you and I don't have to go wo money for weeks during a banking holiday). However, some argue that they are too lenient on the banks.
    The recurrent dilemma in (fractional reserve) banking is how to square the twin objectives of investment financing (that is risky) with a safe medium of exchange (which should transact at par). Hy Minsky has made the point that this issue has been a recurrent theme in American banking since the conflict between President Jackson (of the US) and Nicholas Briddle (President of the Second Bank of US) over the chartering of that bank. The entrepreneurs in the West wanted more development financing for railways and waterways, while the defenders of the bank wanted safer investments to protect the banks solvency and not compromise its liabilities.
    The key is to straddle the two functions. 100 % reserve banking would leave the investment function entirely to the private sector. Not sure if that is a good idea, especially these days when companies are stacking up cash, and pensions funds and insurance companies are retreating from long term investment (see chapter 2 of the newly issued IMF: GFSR for more on this issue).

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  20. David:

    They resumed convertibility in 1821. Here's the British CPI over the period:

    Table 1. British Price Index (1782=100)

    Year Prices Year Prices
    1792 93 1807 132
    1793 99 1808 149
    1794 98 1809 161
    1795 117 1810 164
    1796 125 1811 147
    1797 110 1812 148
    1798 118 1813 149
    1799 130 1814 153
    1800 141 1815 132
    1801 153 1816 109
    1802 119 1817 120
    1803 128 1818 135
    1804 122 1819 117
    1805 136 1820 106
    1806 133 1821 94

    A pet theory of mine, not very well-documented, is that the 1930's were worse than the 1830's in part because banks were able to suspend in the 1830's, but not in the 1930's. This led to worse runs in the 1930's, and a bigger drop in the money supply.

    Also, I mistakenly said liquidation of banks can avoid huge drops in the money supply. I should have said that devaluation of the bank's money avoids the drops in M.

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  21. "You agree with me that it's a put option...lol. I'm not sure really"

    So it's either a call option or a put option, for simplicity. The difference is with a put the redemption price is known beforehand; with a call, the redemption price is unknown beforehand. At least that's how I look at it in terms of what I see when I buy one. Classifying a put as the right to sell and a call as the right to buy misses that transactions are reciprocal (i.e. I can buy money with a stock or I can buy a stock with money; the important things are whether the price is known or unknown and whether it's a right or an obligation).

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  22. Thanks for the usual banker's point of view. I'm happy for you that you think the world economy is working so well under this system, but where I live it is drowning the economy in debt.

    Like most, you get caught up in everyday transactions and ignore the big picture: in many economies Fractional Reserve Banking is the only way to increase the money supply - and that means virtually all money is created as DEBT.

    I'm seeing an increasing amount of this pro-bank propaganda that banks don't create money via FRB - laughable. Please tell me then how the US money supply went from $300 Billion in 1970 to 15+ Trillion now?

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  23. I am not saying it's working fine; agree fully about money creation and huge instability. But, what to do with it? I'm just making the point that there are no easy ways out, and we need a workable payment system, but also investment to grow. So are you for 100 % banking, and if so who will finance investment?

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  24. very nice and clear, indeed. I only would add a comment: in the case of 100% deposits, to have money at banks would cost some money to depositors.

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  25. @Mike: wow, redemptions did not resume until 1821? However, following a short inflation, we see relative price level stability, then falling prices (possibly anticipating the return of convertibility?)

    @TJ: I was not presenting a "banker's" point of view; I am presenting the facts. Also, I cannot recall saying that the economy is working "so well" under this system. My post also makes clear that bank money is debt. I'm sorry that you find my writing so difficult to comprehend.

    @Luis: thanks! Yes, I was thinking of mentioning that (and several other things), but the post was already getting too long!

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  26. David, do you think that 100% of reserve could mean the return the usury?

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  27. Luis, please elaborate (a return of "usury"?)

    An hypothetical (in my view, it would never happen) policy of 100% reserve requirements would (apart from its initial disruptive effects on credit markets) would lead to a massive expansion of the shadow-banking sector. People leaving their funds in banks would have to consign themselves to a negative (say 2%) real rate of return on there savings (narrow banks would have to levy a service charge to fund operations). Not sure if I answered your question though.

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  28. Sorry, I´m thinking in a return to usury, scarcity of credit and huge rise of interest.
    I agree taht it will be a massive expansion of the shadow-banking; I was thinking if that also would no be authorized.

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  29. Luis, yes, one might reasonably expect interest rates to rise (ceteris paribus) primarily because creditors would now have to be compensated for the loss of their redemption option. This will be doubly true if shadow banking is shut down (the elimination of short-term debt to finance longer term assets). Creditors would have to be compensated for taking on longer term debt. I'm not sure though. Perhaps you have a few thoughts on the matter?

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  30. "our most recent financial crisis was centered in the repo market--the shadow banking sector"

    So yes I think this had a lot to do with it but it isn't necessary to precipitate a financial collapse. Derivatives added to the confusion for sure and led to nobody trusting anyone because trades would collapse in uncertain ways. Incorrectly marking massively over-inflated assets to market would probably have done it too, even without all the shadow stuff. JMHO

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  31. I'm in favor of what it says to do in the Constitution: direct democratic rational control of "coining" money. The money supply needs to grow in proportion to the GDP, the Founding Fathers spent money into existence to build infrastructure.

    What happens now is people work and innovate and grow the economy, but the only place to get the additional money to represent that productivity is to borrow it. FRB forces any growing economy into debt. When every dollar is created as debt there is no other possible outcome but what we are seeing: individuals, businesses and governments buried in unsustainable exponentially increasing debt.

    Banks can still lend all the money they want, as long as they actually own that money and are taking a real risk in return for the interest. They get to lend like you and I can lend, not counterfeit, equality = free enterprise.

    Monetary reform is coming to the floor in congress: H.R. 6550, and many states have bills to create state-owned banks like the Bank of North Dakota which has kept the state out of crushing debt and with low unemployment.

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  32. TJ, is there something in my post that you disagree with specifically? If so, please identify the offending passage and tell me why it is wrong. Let's talk about it. (And you evidently have a poor knowledge of your own history. Do you know where the phrase "not worth a Continental" comes from? Here, let me help you: http://www.journalofantiques.com/june04/coinsjune04.htm

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  33. @David Andolfatto: What did I not comprehend? The whole point of your article was to refute the idea that FRB is sapping the wealth of the economy - that's is what you say in the first paragraph. Everything you wrote is minutiae to defend the banking status quo.

    You also claim creating all money as debt is "irrelevant". Or did I make that up too? Because I don't see any "facts" or logic in response to my post saying why it is obviously not irrelevant.

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  34. TJ, no, this post does not constitute a defense of the status quo. It constitutes a rebuttal against the notion that "fractional reserve banking constitutes counterfeiting or theft."

    If a company was to over-issue shares, say, to finance the vacation of a CEO, I would also call this counterfeiting and theft. I am against that sort of behavior, as I'm sure you are too. But it has nothing to do with fractional reserve banking, does it?

    I also did not claim that creating all money out of debt is irrelevant. I'm afraid that you'll have to go back and re-read what I wrote. You evidently have some trouble absorbing my prose. Please take your time this time and try not to get too excited.

    ReplyDelete
  35. Edward said...

    @ David

    What do you think of the Rothbardian argument that bank loans over certain time periods need to be representative of the markets willingness to invest that money over a certain time?

    Meaning a bank must secure 10 year time deposits in order to loan money out for 10 years. This, in theory, would end both kinds of bank runs because checking accounts would be backed by 100% reserves and 10 years loans would only be lent out from 10 year time deposits.

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  36. Edward:

    Yes, the idea that debt and asset maturities should be matched is an old idea. I believe that such a structure would have the effect of eliminating bank-runs and "bank-run-like" phenomena.

    The question, however, is whether such a debt structure might come at some cost?

    To put the question another way: Is there any underlying efficiency rationale for "maturity mismatch"? And in particular, for the practice of using short-term debt to finance long-term investments?

    According to Calomaris and Kahn, which I cite above, maturity mismatch might be a way of making sure that bankers have reduced incentives to abscond with depositor funds.

    There may be other reasons as well. We live in a "second-best" world, so that no particular structure is likely to be perfect. There are likely to be trade-offs. We should think about what these trade-offs might be before rashly concluding that one system is obviously superior to another.

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  37. Oh I get it - I write something, and you don't respond to it with any facts or logic because it's easier to claim I don't understand you.

    You start the article saying you are going to refute the "misleading" idea that FRB is sapping the wealth of the economy. Then you write a bunch of minutiae on the micro transaction level (which is odd for a "macro" article).

    When I point out you are missing the big picture reason how FRB is killing the economy, you ignore it and claim I don't understand what you wrote. What fun!

    Do I need to re-read this again: "Now, the commentator in that video claims that this bank-money is created out of thin air. That is both correct and completely irrelevant"

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  38. TJ, TJ...I told you to relax and take your time.

    Here is your original claim of what I said (see your comment @12:54PM):

    You also claim creating all money as debt is "irrelevant". Or did I make that up too?

    And now, I see that you quote me correctly:

    Now, the commentator in that video claims that this bank-money is created out of thin air. That is both correct and completely irrelevant.

    Can you not see the difference in these two claims? If not, perhaps this is a good place to stop. (And btw, I pointed you to another link where I explain in greater detail what I meant by "irrelevant." I trust that you did not bother to follow the recommendation.)

    ReplyDelete
  39. Lol.

    http://www.ronpaulforums.com/showthread.php?317043-Some-Fed-shill-defending-fractional-reserve-banking-(surprise)-anyone-got-a-response

    That was my attempt at getting the Rothbardians to attack, I don't believe it has worked. Anyway, great post David. Your stuff is much, much better than the polemical tripe found on the vast majority of "economics" blogs.

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  40. @David Andolfatto and although I realize this is just another attempt to distract from the main points I have made and you have ignored - I wasn't talking about the 'continental', I was talking about Colonial Scrip. I guess you would rather get into endless bickering over historical trivia than talk about the major issues I raised.

    If I'm not super calm it's because I see people really suffering from what is happening to the economy, and I'm not thrilled with people defending the status quo and trying to use distracting trivia to discredit those fighting for a solution.

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  41. OK TJ, sorry about that. Perhaps we can continue this discussion at some other time. In the meantime, I wish you all the best of luck.

    ReplyDelete
  42. @David Andolfatto And yes, if you are going to continue to ignore the points I made about how FRB is killing the economy with debt, and instead quibble over what you meant by "irrelevant", or what the definition of "is" is, it is a good time to stop. Your agenda is obvious.

    ReplyDelete
  43. Edward says...

    @ David

    Although I gave the Rothbardian argument, I am not a Rothbardian. I lean more with Hayek and his idea of a totally free market in money and banking.

    I do find Austrian Business Cycle Theory incredibly interesting. For those who aren't familiar with it, ABCT sees a much greater problem than just price inflation and possible bank runs with credit expansion. Proponents argue certain interest rates over certain time periods are a direct representation of peoples desire for immediate consumption vs. postponed consumption. When a bank finances long term projects with short term debt that must be rolled over, it artificially pushes long term interest rates down, thereby directing real resources into capitol goods/projects that otherwise would not have been profitable at a higher interest rate. In reality, they are still probably not profitable, and when too many resources are pushed into unprofitable capital projects, those projects must be liquidated, causing a depression.

    The general argument is that pushing long term interest rates lower than the market dictates, distorts the capital structure of an economy and a liquidation period must ensue in order to set things right again. That is a very short and crude explanation of a very complicated theory, but this is a blog.

    So David, do you think there is anything to the theory of maturity mismatch, long term interest rates, and unprofitable long term capital projects?

    ReplyDelete
  44. Fed Girl - Audit The Fed, End The Fed
    http://www.youtube.com/watch?feature=player_embedded&v=yFjSE7YdiQ8#t=110s

    ReplyDelete
  45. Edward,

    I started a while back to acquaint myself more with the Austrian school (and the evolution of the history of economic thought since Wicksell, and before). There is much that appeals to me, but I am not sure of many of the propositions put forth. (Largely, this is because so little of their work appears to have been formalized mathematically.)

    So, for example, when you say:

    When a bank finances long term projects with short term debt that must be rolled over, it artificially pushes long term interest rates down, thereby directing real resources into capitol goods/projects that otherwise would not have been profitable at a higher interest rate.

    That is a theoretical proposition that needs to be proven, not simply asserted. I am sure that it may constitute a valid statement under a given set of assumptions. But what are these assumptions and are they mutually consistent with each other? How can we know? I am still trying to figure things out.

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  46. @Anonymous,

    Thank you for posting that youtube video by the "End the Fed" girl.

    Let's see if I understand her position correctly. I think it is this: "We should hold a fair trial, and then we should convict the bastard." Have I got it just about right? Why bother with the pretense of an audit. Just end the Fed.

    By the way, she neglects to mention that the Fed actually made money for the U.S. taxpayer in its lending operations. Oops.

    Finally, as for information disclosure at the Fed, I wrote this piece some time ago.

    http://andolfatto.blogspot.com/2010/04/information-disclosure-policy-for-fed.html

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  47. Good article but I don't understand your explanation of fractional reserve banking

    As I understand matters fractional reserve banking lending restrictions no longer applies

    It use to when bank lending was restricted by base money. Base money = notes and coins + central bank credit (bank reserves)

    Banks could only in theory loan say 90% of their base money. But banks started to ignore this lending restriction and started to instead obtain reserves to settle with other banks if required after the event. Eventually fractional reserve banking restriction were dropped completely.

    Today bank lending is restricted by capital ratios.

    But many so called monetary reformers still have not caught on yet. It often goes hand in hand with so called debt free money. Credit always = debt but try explaining that to debt free money supporters.

    ReplyDelete
  48. "like most, you get caught up in everyday transactions and ignore the big picture: in many economies Fractional Reserve Banking is the only way to increase the money supply - and that means virtually all money is created as DEBT."

    TJ

    Read this

    You have a confused view on what money is

    http://moslereconomics.com/mandatory-readings/what-is-money/

    Money is the credit entry of the debit and credit accounting entry that is made (nowadays on computer screens) when goods, services or assets are traded by two willing parties.

    And new credit (money) can only come into existence with an offsetting debt

    Money = credit = debt

    Debt is either

    Govt debt (from Govt deficits) or
    Non Govt debt (fron bank loans or overdrafts)

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  49. I think that these discussion are not very usefull if we don´t see to the history. The history says that fraccional reserve has not impede the huge progress of the economy through the centuries having been an habitual fact. There has been financial crisis time to time, but it will be erroneous to asign them to fraccional reserve.
    The libertarians/rothbarians take as a definite proof some remote times in a remote zone that would have experienced free banking and or 100% reserves. What we know of these remote times is not sufficient to prove that stability and happiness were greater than today.

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  50. "Free banking and 100% reserves"

    These are other flawed ideas from many so called money reformers who are really quite ignorant of money and banking as it operates today. And really always has.

    ReplyDelete
  51. ron paul and his looney followers are flooding the internet with highly politically biased disinformation

    ReplyDelete
  52. "If I'm not super calm it's because I see people really suffering from what is happening to the economy, and I'm not thrilled with people defending the status quo and trying to use distracting trivia to discredit those fighting for a solution."

    And the cause is fractional reserve banking? I spit my coffee on my keyboard.

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  53. FRB is by nature unstable. If we all would live in tents, there would not be banking crises (quote from Martin Hellwig). However, long term investment is required for growth, and thus maturity transformation. Problem was banks got hijacked by traders in the 90s. They blew leverage through the roof (in the UK it increased from 20 to over 40 in 2000-08). And compromised the payment function at the same time. Policy makers are trying to put this genie back in bottle. Not easy. US would shed some prop trades and UK will ring-fence banks, but defining what should be in or out is hard. A possible solution to save the payment function could be to put retail deposits in a separate subsidiary or even make it a public utility (see Tobin on this at Jackson Hole in 1987). Sort of 100 % solution, but would still have commercial banks operating alongside the utility as well as separate investments banks. this may be dull banking stuff, but this is where the policy discussions are today.

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  54. David Andolfatto, First, I agree that many, if not most opponents of fractional reserve are clueless.

    However, there is a flaw in your argument that monetizing the restaurant building is harmless. The flaw is that the cost to a bank of producing the money out of thin air (using the building as collateral) is in principle nothing: it’s just a book keeping entry. Thus if the restaurant produces a ludicrously low return on capital, it will still pay the bank and restaurant owner to go ahead. And that will drive other and more productive businesses out of business. In short, fractional reserve reduces interest rates to an artificially low level.

    Of course there are administration costs involved in the above process, but admin costs apply to all forms of banking and all businesses, so the “admin” point is irrelevant.

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  55. David Andolfatto,

    Re your claim that there are only two ways of stopping bank panics, neither of which are wholly effective, I suggest there is a method that reduces the chance of panic to virtually zero. Moreover, this method disposes of the taxpayer subsidy of banks and commerce in general that is inherent in our existing bank system. This method was the main element of a submission to the UK’s Independent Commission on Banking. See:

    http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf

    It goes like this.

    Depositors have to make a choice between 100% safe taxpayer backed accounts and accounts where their money is loaned on. As to the first, the money is lodged at the central bank, so (blatant criminality apart) there is no chance of the money being lost, nor do depositors get much interest. As to the second type of account, all deposits would be time deposits, and in recognition of the fact that their money has been loaned out for a significant period. In other words maturity transformation is curtailed.

    Panic withdrawals from the first type of account would do no harm because the money is there. As to the second, instant withdrawal is just not allowed.

    As Mervy King, governor of the Bank of England put it, “If there is a need for genuinely safe deposits, the only way they can be provided, while ensuring costs and benefits are fully aligned is to insist such deposits do not coexist with risky assets.” In other words, quite apart from the defects of fractional reserve, lending on money from 100% safe taxpayer backed accounts is a taxpayer funded subsidy of commerce.

    ReplyDelete
  56. Anonymous @12:54AM

    As I understand matters fractional reserve banking lending restrictions no longer applies.

    You are right that banks have to worry about capital ratios and all that, but this is not the point of my blog. It is still true that that retail banks issue demandable liabilities (convertible to cash on demand) and that the aggregate liabilities of the banking sector exceed the value of aggregate cash reserves. Which is to say, we have a fractional reserve banking system.

    @ntbgm1: However, long term investment is required for growth, and thus maturity transformation.

    I do not see the link. Why not finance long term investment with long term debt? The maturity transformation likely has some role to play in aligning incentives, a la Calomaris and Kahn.

    ReplyDelete
  57. @Ralph Musgrave:

    However, there is a flaw in your argument that monetizing the restaurant building is harmless. The flaw is that the cost to a bank of producing the money out of thin air (using the building as collateral) is in principle nothing: it’s just a book keeping entry. Thus if the restaurant produces a ludicrously low return on capital, it will still pay the bank and restaurant owner to go ahead. And that will drive other and more productive businesses out of business. In short, fractional reserve reduces interest rates to an artificially low level.

    Ralph, your argument applies to any debt-issuing agency, including individuals who make false promises. It has nothing to do with fractional reserve banking, per se. For example, if General Motors acquires funding by creating shares out of thin air, then blows the investment, bad things will happen. Right?

    I spoke too quickly when I said there are "basically two ways" to avoid panics. Clearly, as my astute readers here have pointed out, there are more than two ways! Thank you for the link -- I will go study it now.

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  58. @Ralph Musgrave:

    Depositors have to make a choice between 100% safe taxpayer backed accounts and accounts where their money is loaned on. As to the first, the money is lodged at the central bank, so (blatant criminality apart) there is no chance of the money being lost, nor do depositors get much interest. As to the second type of account, all deposits would be time deposits, and in recognition of the fact that their money has been loaned out for a significant period. In other words maturity transformation is curtailed.

    Yes, I've heard of similar types of proposals. I certainly think they might have the effect of curtailing bank panics at the retail (but not wholesale) level. May I offer a critique of this position?

    [1] If there truly is a demand for 100% cash-backed deposits, is there anything that is preventing the private sector from offering this service now? I don't think so (though I could be wrong). And if not, then why don't we see it? (I suggest that it is inefficient; that consumers don't want it).

    [2] Your proposal to curtail maturity transformation implicitly assumes that there is "too much" maturity transformation going on. How does one know this? How does one know this, in particular, without a theory of maturity transformation? (Not claiming that you do not have one, but what is it?) I am aware of theories that suggest that maturity transformation is playing an important role in aligning incentives (so that bankers do not abscond with funds, for example). Restricting the finance of investment with time-deposits may, in fact, prove to be more costly. There may be unintended consequences, in other words.

    Any thoughts?

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  59. There is no demand (or supply) for 100 % money because cost of current system is not stated upfront (e.g. some trillions now and then for banking crises clean up). Regular banking services should be higher compared to a 100 % bill.

    You cannot leave maturity transformation entirely to the market. Banks have comp advantage in underwriting and should continue doing so, but without the prop trad part.

    Even Lord Turner admits there have been too much maturity transformation. He wants bank to shed the casino business, ref. Fundamental review of trading book in Basel

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  60. David Andolfatto: You ask why we don’t see 100% cash-backed accounts. I think the reason is thus. Such accounts necessarily pay little or no interest because the money deposited is not invested. The “interest” might even be negative in that banks incur costs maintaining such accounts.

    Now why would anyone go for such an account when they can get a 100% safe taxpayer backed account where the money is invested – perhaps in a risky manner – and the taxpayer foots the bill if it all goes wrong?

    Re maturity transformation, I don’t have any desperately sophisticated “theories”. But maturity transformation certainly has its defects. First it makes banks more fragile.

    Second, it strike me that there has to be some optimum rate of interest, just as there is an optimum price for steel, apples, etc. And the reasoning behind what brings that optimum rate is much the same as the reasoning behind what brings the optimum price for steel and apples.

    This is that the marginal benefit from borrowing should equal the marginal disutility / pain from forgoing consumption with a view to saving.

    Thus ideally someone who wants to borrow $X for Y years should have to find a person or persons prepared to forgo consumption worth $X for Y years.

    The Werner / Positive Money work I linked to above does not advocate a full ban on maturity transformation, but it makes a move in that direction.

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  61. Ralph,

    You raise a good point about the present existence of federal deposit insurance. However, I seem to recall the lack of 100% reserve banks even prior to the FDIC. So your explanation is not entirely satisfactory.

    I can identify "defects" in all sorts of things, Ralph. It has been my experience, however, that such "defects" are sometimes playing a useful social role in a world of financial market frictions. There are trade-offs. How can we say for sure that there is "too much" or "too little" maturity transformation without first having a good theoretical understanding of what possible role the institution is playing?

    Thus ideally someone who wants to borrow $X for Y years should have to find a person or persons prepared to forgo consumption worth $X for Y years.

    Is this a theoretical proposition; and, if so, please state your assumptions and lay out the proof for us.

    Thanks!

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  62. David Andolfatto, I forgot to say . . . my suggestion above that interest rates should be set by the market implies there is something wrong with central banks setting such rates. I actually set out a string of problems involved in having central banks set interest rates at the URL below. It’s probably not the most sophisticated attack on interest rate adjustments you’ve come across, but I try my best!

    http://ralphanomics.blogspot.com/2010/12/interest-rate-adjustments-are-useless.html

    ReplyDelete
  63. kiwi

    "You are right that banks have to worry about capital ratios and all that, but this is not the point of my blog. It is still true that that retail banks issue demandable liabilities (convertible to cash on demand) and that the aggregate liabilities of the banking sector exceed the value of aggregate cash reserves. Which is to say, we have a fractional reserve banking system"

    FRB has been dropped.

    Money = credit and credit = debt

    To say we have FRB banking because banks do not hold notes and coins to support 100% bank deposits is not a valid argument. It would be pointless to hold all this cash. Cash that can be printed when required anyway.

    And if you are referring to Fed reserves. These can be created by accounting entry by the Fed as required.

    The key is bank credit. This is real money. It is not a fraction of anything but stands alone.

    FRB was only ever a means to restrict new bank loans (and the resulting equal new bank credit or customer deposits) anyway nothing more.

    It is and always was an area of great confusion though. But its surely time to move on now.

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  64. Kiwi

    Ralph

    "In other words, quite apart from the defects of fractional reserve"

    FRB no longer exists (this is beyond debate and for so called monetary reformers like positive money to not know this is almost unbelievable).

    And as I said above it was only ever a means of restricting bank lending nothing more

    Money is credit. Credit is always supported by debt and nothing but debt. So debt free money can not exist either. Debt free money is often confused with Govt debt classified as ??? Ask peopel and they often are ignorant of simple double entry bookkeeping

    Why is there so much confusion around this.

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  65. Kiwi

    Ralph

    "I actually set out a string of problems involved in having central banks set interest rates at"

    How can they not set interest rates.

    http://moslereconomics.com/support/

    The Fed is the monopoly supplier of net reserves to its banking system, and, therefore has no option but to set at least one interest rate.

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  66. " If there truly is a demand for 100% cash-backed deposits, is there anything that is preventing the private sector from offering this service now? I don't think so (though I could be wrong). And if not, then why don't we see it? (I suggest that it is inefficient; that consumers don't want it)"

    The central bank is the lender of last resort. So if one bank is short of Fed reserves and can not obtain them from other banks etc. the central bank will step in anyway so what's the problem.

    This 100% banked money will achieve nothing. And is based on confusion about what money is.

    It is based on bank credit not being real money. And that bank reserves is. This is flawed logic.

    Bank credit or deposits is real money (always backed by debt through commercial banks). Bank reserves (central bank credit) is just a means for banks etc to settle with other banks. It can not be spend in the real economy

    Its important but is not superior to bank credit. And like bank credit is just created by journal entry. (It is released mainly by Govt deficits).

    It is a Govt liability but bank asset

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  67. David Andolfatto,

    Re your point about General Motors above, isn’t that a “two wrongs make a right” argument? I.e. the fact that GM can throw shareholders’ money down the drain is not an excuse for having a bank system that facilitates near zero return on capital investments, or other daft investments, like NINJA mortgages.

    Re your point about the lack of full reserve accounts prior to FDIC, that is an interesting point. Possibly the reason that full reserve accounts were not available prior to FDIC is that banks are hardly likely to put adverts in the press saying “Your money is not 100% safe with us, but if you want 100% safety, we can offer full reserve accounts”. Also banks make their money from lending on depositors’ money, so absent the sort of legislation advocated in the Werner / Positive Money paper, banks are just not interested in providing full reserve accounts. Plus I imagine 95% of depositors have no idea what monetary base is or what a full reserve account is. Unless the idea of a full reserve account is carefully explained to them, the idea will never occur to 95% of them.

    Re maturity transformation (MT) and your request that “lay out the proof for us”, I’m not confident that I’ve got to bottom of this matter. So the following are just some random thoughts.

    First, to repeat, MT makes banks more fragile. So what are the merits in MT to balance that demerit? A popular alleged merit is that MT enables banks or society as a whole to use idle money. Put another way, for a given stock of money, curtailing MT would restrict bank lending and curtail economic growth.

    But the flaw in that argument is that money in bank accounts are no more than numbers in a computer. Money in a bank account does not equal real savings. Put another way, if we curtail MT, the deflationary effect can easily be countered by expanding the money supply. As Milton Friedman put it in his book “A Program for Monetary Stability”, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”

    Another argument for curtailing MT is intertwined with the argument for banning fractional reserve, i.e. stopping commercial banks from creating money. The argument is thus.

    As the text books explain, people keep money for a variety of reasons including the so called transaction motive. This is money which depositors clearly do not want to lose. And that in turn means it needs to be 100% safe, which in turn means it cannot be invested. But MT allows banks to invest a portion of this transaction money. But we should not allow 100% safe, taxpayer backed money to be invested, as that involves a taxpayer funded subsidy of commerce. Ergo MT should be curtailed to some extent.

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  68. Hi Richard:

    Re your point about General Motors above, isn’t that a “two wrongs make a right” argument?

    Most definitely not. I am making the point that the "theft" that people like to attribute to fractional reserve banking has nothing to do with the fractional reserve system, per se.

    As for the rest of what you say, I'm not about to disagree with it. You still leave me puzzled, however, with respect to the question of how one might know whether there is "too much" or "too little" MT out there!

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  69. Anon, Re interest rates and Warren Mosler’s site, I look at his blog every day, and it was a link on that site that lead me to this Macromania site.

    I agree that central banks inevitably set the yield on government debt. But they don’t have complete control over other rates, e.g. rates on credit cards, mortgages, etc. What they try to do is influence the latter rates by adjusting the former. I don’t think they should do that (and I don’t even think they have much success when they try). As far as I can see, Warren Mosler agrees in that he thinks the rate on government debt should be permanently set at zero. Milton Freidman thought the same. See:

    http://nb.vse.cz/~BARTONP/mae911/friedman.pdf

    Incidentally, Friedman also advocated full reserve banking in that paper.

    For Mosler, see 2nd last para here:

    http://www.huffingtonpost.com/warren-mosler/proposals-for-the-banking_b_432105.html

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  70. Can anyone explain what this little blog clique's motive is for defending FRB to the point where you are in some kind hysterical panic that you can ignore over and over again the elephant in the room even when it is pointed out to you:

    When every dollar is created as debt there is no other possible outcome but what we are seeing now: individuals, businesses and governments buried in unsustainable exponentially increasing debt.

    Or does your smug little status quo denial syndrome prevent you from even seeing that paragraph?

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  71. "Can anyone explain what this little blog clique's motive is for defending FRB to the point where you are in some kind hysterical panic that you can ignore over and over again the elephant in the room even when it is pointed out to you:"

    Maybe if you moved forward to the 21st century. FRB has been dropped and no longer applies as explained above.

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  72. "Incidentally, Friedman also advocated full reserve banking in that paper."

    This is based on confusion about money and what banks do.

    It has zero relevance today especially now that FRB restriction no longer apply. And we are no longer on the gold standard.

    The main problem today is ignorance about money and banking. Warrens MMT site is one of many trying to correct the confusion (his free download book is brilliant and should read by everyone who is interested in this subject)

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  73. @TJ: The issue, as far as I can see, is not that money is debt. The issue concerns how well the debt is backed.

    @Anonymous: I'm not sure what justifies your claim that "FRB has been dropped." Banks still make money loans convertible to cash. There is less cash than loans. Ergo, we still live in a FRB setting. But obviously, I am missing something.

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  74. @anonymous you say "FRB has been dropped and no longer applies as explained above."

    Seriously? Can you point me to the Wall Street Journal article that broke the story on this huge change in our monetary system?

    And please do tell me then - what mechanism for money creation has taken its place? Continuing to create all money as debt is crashing the global economy, but you claim that now there is no mechanism for money creation at all?! Seriously, is this little blog clique from a bunch of community college Econo 101 students discussion group?

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  75. TJ, if you want me to keep your comments here, please keep your insults to yourself. One or two, and in good fun, might be OK. But you are going a little too far now. Let's keep things constructive. Thx.

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  76. @David Andolfatto So you think an exponential increase in debt/money creation is sustainable? Pretty soon the national debt/money creation will be increasing by a trillion a month, then a week, then a day, then a second - that works for you? It doesn't work for our credit rating.

    You still don't get that the problem is that what backs the debt doesn't matter if all that increased productivity is represented by dollars created as debt. What backs the debt, our real economy, should be doing just fine - a motivated educated workforce with unprecedented technological productive potential. But instead of the increased GDP being represented by real money - it is represented by debt.

    If on payday your boss told you your check was a loan - would you accept that? Of course not because even though you would have money to spend, you'd realize you would end up owing everything to the lender.

    But that is exactly what we have collectively accepted with FRB. A nation does everything right to increase productivity, but instead of the expansion being rewarded with a real money payday, the expansion can only happen by borrowing to create the money.

    What planet are you people on that you think the economy is going well and there is no debt crisis?

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  77. @David Andolfatto I think it's great you want to keep things civil. Could you point that out to your allies who call anyone who disagrees with your little clique "clueless" and "ignorant" instead of responding to the facts and logic of their points.

    It's hilarious I still see people here claiming FRB doesn't really create money, haven't any of you ever seen a graph of the M3? (At least before the Fed started hiding it in 2006).

    ReplyDelete
  78. TJ

    "Continuing to create all money as debt is crashing the global economy"

    Rubbish

    Money (credit) is always backed by debt. It is backed by debt and nothing but debt

    Either
    Govt debt or
    Non Govt debt

    There is no way around this. Debt free money is a myth where promoters plan to use creative (fraudulent) accounting to hide Govt debt in another treasury account

    Some recommend crediting treasury revenue rather than liability Govt debt (see article below) but this is not in accordance with international accounting standards. (And is basically wrong anyway)

    http://www.correntewire.com/coin_seigniorage_and_irrelevance_debt_limit

    I suggest you read this article on money. And stop reading sites from confused so called money reformers that do not understand double entry bookkeeping or what money is.

    http://moslereconomics.com/mandatory-readings/what-is-money/

    ReplyDelete
  79. @Anonymous: I'm not sure what justifies your claim that "FRB has been dropped." Banks still make money loans convertible to cash. There is less cash than loans. Ergo, we still live in a FRB setting. But obviously, I am missing something.

    Money is credit and nothing but credit. It is not notes and coins

    All notes and coins do is allow credit to be exchanged (by a buyer to a seller) without cheques or debit cards etc

    Its a means of convenience. The key is credit NOT notes and coins.

    MONEY = CREDIT = DEBT

    Credit came first and is money today and has always been money.

    Whether credit is more or less than notes and coins is of zero relevance.

    http://moslereconomics.com/mandatory-readings/what-is-money/

    In China, also, in times as remote as those of the Babylonian Empire, we find banks and instruments of credit long before any coins existed, and throughout practically the whole of Chinese history, so far as I have been able to learn, the coins have always been mere tokens.

    There is no question but that credit is far older than cash.

    From this excursion into the history of far remote ages, I now return to the consideration of business methods in days nearer to our own, and yet extending far enough back to convince the most sceptical reader of the antiquity of credit.

    ReplyDelete
  80. "It's hilarious I still see people here claiming FRB doesn't really create money,"

    This si back the front

    FRB never created money. This is based on confusion about FRB (that many still hold onto)

    Banks create new money (bank credit) when they allow a negative credit balance

    The bank journal entry for a loan is

    DEBIT Customer loan (bank asset customer debt)
    CREDIT Customer deposit / cheque account (bank liability customer asset)

    FRB use to just LIMIT the amount of negative credit balances (loans or overdrafts) bank could allow

    So rather than FRB creating new bank credit it restricted the amount that bank could create. The restriction was based on base money held.

    ReplyDelete
  81. If you can't respond directly to my points don't bother with endless links and inaccurate histories that claim the system we have now has been in existence for ever and so is infallible. FRB has been around a long time and come and gone, but since the Nixon Shock, never has it been completely untethered from reality in a economy with computerized lightning fast technology as it is now, resulting in the insane explosion of debt/money.

    I guess you'll all still continue to ignore things like the fact that the money supply has increased from ~$300 billion at the time of the Nixon Shock in 1971 to $15+ trillion today.

    I'd love to be wrong, I could sleep better at night if I thought maybe there was a chance that we're not headed off the cliff of a global depression.

    So please all you genius experts answer THIS ONE QUESTION - where did all that $15 Trillion come from unless it was all created as debt that needs to be paid back with interest - and the only place to get money to pay it is create even more debt/money.

    ReplyDelete
  82. TJ, who owns that $15 trillion of debt?

    ReplyDelete
  83. TJ

    "So please all you genius experts answer THIS ONE QUESTION - where did all that $15 Trillion come from unless it was all created as debt that needs to be paid back with interest - and the only place to get money to pay it is create even more debt/money. "

    New credit can only come into existence with an exact equal increase in debt

    This is an easily provable fact

    And the debt is either

    1 Non Govt debt from either an overdraft or bank loan
    2 Govt debt from Govt deficits

    And debt in total must NEVER be paid back. As debt = credit = money. Without debt there is no money

    And why do we need more debt and credit.

    For saving as we age

    Money /(credit) is required for two reasons

    Consumption and
    Financial savings

    So as the population ages then the money supply (and debt) must increase.

    For example country A needs 100 million for consumption. This can not be touched for savings otherwise it is locked out for consumption.

    But if another 100 million is required for savings in say a pension fund. Then country A must use new bank credit to invest in pension funds (B). B will initially receive this 100 million from A for pension payments. But this must be invested in assets (not consumed) for obvious reasons.

    This bank credit for financial savings can only come from [the asset held to offset the bank deposits] either:-

    New Govt debt (from running deficits) or
    Private debt (from new bank borrowing)

    There is no other place it can come from

    So with an ageing population

    The money supply must increase and
    Debt must also increase. Either Govt debt or non Govt debt.

    The ONLY WAY TO RECTIFY THE CURRENT PROBLEM THE WEST HAS IS TO

    Run large Govt deficits (say by large tax cuts)
    AND
    Where required drain excess reserves with investment pension (non bank) bonds

    ReplyDelete
  84. Sorry this last sentence should say

    drain excess bank DEPOSITS with investment pension (non bank) bonds

    ReplyDelete
  85. I guess you'll all still continue to ignore things like the fact that the money supply has increased from ~$300 billion at the time of the Nixon Shock in 1971 to $15+ trillion today.

    15 trillion is clearly insufficient

    The US accrued liability for pension and health care is over 100 trillion. if this was funded totally then

    Govt should run deficits until Govt debt = 100 trillion and
    Issue pension investment bonds of 100 trillion

    NB The burden on the non bank sector to fund all or the majority of pension savings is just too much. It can pick up some of this debt burden but not much. It's the main problem we have now. Too much non Govt debt. Not enough Govt debt.

    Also read this

    http://rodgermmitchell.wordpress.com/2010/08/13/monetarily-sovereign-the-key-to-understanding-economics/

    ReplyDelete
  86. TJ

    "So please all you genius experts answer THIS ONE QUESTION - where did all that $15 Trillion come from unless it was all created as debt that needs to be paid back with interest - and the only place to get money to pay it is create even more debt/money. "

    And I don't want to post too much on this

    But the interest problem more debt is another monetary reform site 'the banking system is flawed' complete myth.

    Firstly the only issue might be bank profit after dividend NOT interest revenue (for obvious reasons). But even this is not an issue if Govt debt exceeds banks retained earnings

    I can give a very simple example to show this but Im sure you can work it out for yourself

    Many monetary reform sites that seem genuine post appallingly confused misinformation. The current system is good EXCEPT for too much non Govt debt and not enough GOVT DEBT. All our current problem flow from this.

    Here is an explanation
    http://www.futureeconomics.org/2010/07/on-the-impossibility-of-paying-interest

    ReplyDelete
  87. David,

    I'm sure you love it at the Fed, but the classroom is where you belong. Excellent post.

    ReplyDelete
  88. @Anonymous:

    Thank you for the compliment. But not sure that I belong in the classroom anymore. I taught a course at SFU last summer. Here is one of the comments I received (via Ratemyprofessors.com):

    What can say David he is not a professor at all. Econ 305 was waste of time and effort. No real final,his midterms questions reflects high school economics. He has to teach at high school & not at Univ. wake up SFU economics department. He is vice president at FED St Louis for this reason USA still suffer from the greatest recession, wake up FED!

    ReplyDelete
  89. David,

    I think that comment says more about the student than the teacher...but I think you already know that.

    ReplyDelete
  90. @ David Andolfatto Wow, thanks for posting that review from a student, especially about your position at the Fed which reinforces everything I thought about your lack of objectivity and open mindedness.

    I've definitely wasted enough time on this little clique that seems to mainly get its rocks off smugly insulting imaginary Rothabrdians.

    BUT you have completely ignored and intellectually been unable to refute my points showing how when you look at the banking system as a whole (y'know the macro view) the infinite expansion of debt is indeed sapping the prosperity from our economy.

    Therefore in the spirit of intellectual integrity I would expect you to remove your claim that view is false from the first paragraph of this article. Please feel free to endlessly blather on about the difference between checks and puts and deposits and cash, just don't claim to draw conclusions you can't defend.

    ReplyDelete
  91. PS: I hope you're thrilled with the way things are going in Europe as the debt dominoes begin to fall - Greece, Italy, Portugal, Ireland, the Euro, the Dollar - crash. Enjoy your wonderful perfect system and all the suffering it is causing as you look down your nose at those trying to find a solution.

    ReplyDelete
  92. TJ, OK, well sorry to have disappointed you so. I thank you for your input and wish you all the best.

    ReplyDelete
  93. "TJ said...

    PS: I hope you're thrilled with the way things are going in Europe as the debt dominoes begin to fall - Greece, Italy, Portugal, Ireland, the Euro, the Dollar - crash. Enjoy your wonderful perfect system and all the suffering it is causing as you look down your nose at those trying to find a solution."

    It would help if you understand how the current banking and money system actually works first.

    All the Euro countries need to do is use the ECB to buy Govt bonds as required. But the Germans and their ignorant dated beliefs will not let them do this.

    The Euro is a complete disaster of an idea and either the ECB continue buying or goodbye Euro.

    ReplyDelete
  94. "TJ said...

    @ David Andolfatto Wow, thanks for posting that review from a student, especially about your position at the Fed which reinforces everything I thought about your lack of objectivity and open mindedness."

    And the world owes the US (and Fed) a massive thanks. Without these Govt and trade deficits the world economy would be in a very sorry state now

    Euro countries on the other hand...

    ReplyDelete
  95. TJ said:

    "I hope you're thrilled with the way things are going in Europe as the debt dominoes begin to fall - Greece, Italy, Portugal, Ireland..."

    What does this have to do with fractional reserve banking? These are stories of sovereign debt crises that could (and would) exist in the absence of fractional reserve banking.

    ReplyDelete
  96. One problem with FRB is that it is a lever - it magnifies changes in the supply of base money. It also intensifies booms and busts.

    The biggest problem however, is that most of the money we use is created by banks (who collect interest on it). If the government wants to run a deficit budget it can't print the money necessary because that would be hyper-inflationary. The government has to borrow the (bank's) money.

    It is this aspect of FRB that is responsible for the sovereign debt crises around the world.

    Who should own the money that gets created? The government or the banks?

    GREG

    ReplyDelete
  97. Hello everyone
    Great posts here! There are great confusion on assets and money out there, that we had collaborated between us to produce a three books series, explaining the banking system, the economic system, in graphical format. There are hundreds of illustrations inside.

    A comment made earlier by TJ was that, to pay a 15 trillion loan plus interest will be impossible because of lack of money in the system, however our calculations showed otherwise. The analogy is simple, if say banking debt is 32 trillion dollars in the economy, and there is 9 trillion dollars of money in circulation, simply use the money to pay the debt, which is now deposited into the deposit side, which can be withdrawn yet again.
    The cycle can go indefinitely, no matter what is the interest and there will be enough money to pay off ALL debts in the economy.

    Money is simply a medium of exchange and can be used over and over again, it is not wealth. We are engineers that are terribly concerned about the state of the public understanding of our money system, created over hundred of years, by our forefathers.

    Authors of 259 Trillion Vs 5 Trillion

    ReplyDelete
  98. To Greg,

    Based on our simulations and calculations, we can confirm it is the government who will get to spend this newly created money.. (In The Conundrum of Assets & Money - Book 1 of the series).

    What the doom and gloom club said that money should be created without interest, we can also confirm that is the case as well...

    Happy New Year Everyone,

    From,
    Authors of 259 Trillion Vs 5 Trillion

    ReplyDelete
  99. Here's why people want monetary reform. None of you get it.

    Step 1. Joe says he wants to buy a car. He has a job and can repay the bank. He has no collateral.

    Step 2. The bank says they will give him the money. But they want the car as collateral.

    step 3. Joe takes the bank-money and buys the car.

    step 4. The economy tanks and Joe loses his job. The bank takes the car.

    So... when the economy tanks, the bank created money and bought a car.

    Now, the central bank hires all of the financial geniuses, and has beyond inside information. So this incentivises them to get a lot of people to put up collateral, like farms, houses, cars, whatever. Then the banks all put up bank-money in return. And then they crash the economy and scoop up all these real physical objects of real value, and it cost them... NOTHING.

    So that's the problem. The whole system incentivises boom bust cycles where banks accrue ownership of all capital. People can claim it doesn't happen. The crashes are not on purpose. But the incentive cannot be denied.

    ReplyDelete
    Replies
    1. Ask yourself this, smart guy: What did Joe give up for the car?

      Delete
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    ReplyDelete
  101. Maybe I'm missing something, quite possible what with the lingo for financial wonks and all, but I don't see how your post is a counter-argument to the video you link to in the first paragraph.

    You begin by criticizing them for failing to mention whether their initial hypothetical $1000 deposit was cash or not, saying that "It makes a difference." Why? This is not made clear.

    Then the post covers what a bank loan is, and the concept of a bank run, their causes, and how to prevent them. I can't see how this is relevant to the argument in the video.

    Does fractional reserve banking increase the money supply as described in the video?
    If so, does this encourage inflation?
    If so does this inflation adversely affect those at the bottom of the economic pyramid (most of us) more seriously than those at the top?

    ReplyDelete
    Replies
    1. Fractional reserve banking does not increase the amount of money in circulation. The amount of money stays the same. Check out our simulation vids.

      When money is in short supply due to increasing level of assets/wealth in the economy, the newly created assets can be brought on to the central bank, and a swap can be made, and fresh money will be injected into the economy. Money printed out of thin air? Not a chance.

      Delete
  102. The theory applies better to bills of exchange. Here an individual actually created a bill in exchange for some good, and that bill circulated onward upon endorsement of individual community members. But that's still pushing it. china manufacturing

    ReplyDelete
  103. The Socialist Anti-Semitic Myth of the Creation of Money out of Thin Air
    http://iakal.wordpress.com/2014/07/04/the-socialist-anti-semitic-myth-of-the-creation-of-money-out-of-thin-air/

    ReplyDelete