Tuesday, October 6, 2009

Weighing In On Fractional Reserve Lending

Mish and Karl Denninger have been having an interesting back and forth on the topic of fractional reserve lending. There is vast disagreement on this subject even within various schools of economic thought. It does not seem to be an ideological debate, but rather a juridical one, which makes it less emotional and perhaps worthy of debate.

Both Mish and Karl bring up good points about what is fraudulent about our financial system. Mish feels it is more systemic and Karl thinks it is a lack of regulatory will (due to capture, corruption, etc). I have stated previously that with a proper legal foundation, no regulation is necessary. So I would have to agree more with Mish. I sent him an e-mail this morning, which I will republish here:


The best arguments against FRL I have read can be found in Jesus Huerta de Soto's Money, Bank Credit and Economic Cycles.

You touched upon this, but de Soto has a better way of explaining it through a historical (dating back thousands of years) understanding on the nature of contract law. When a depositor gives their money to a bank, they are doing so under the impression that the bank keeps their money safe. If this were not the case, people would buy bonds or some other investment. Historically, the act of keeping money safe was a service that depositors would pay for. By lending money out that has been promised to someone else, the bank is abrogating their contract with the depositor. In order to do so, the bank must consider the deposit as an asset, something the depositor simultaneously believes he has. Very simple contract law states that two separate entities can not claim ownership to the same asset. Thus, the bank is guilty of misappropriation by promising safekeeping of something they do not possess.

The confusion seems to surround the difference between two distinct types of contracts: the Monetary Irregular Deposit and the Monetary Loan. Below is a table copied from pp. 19 of Money, Bank Credit and Economic Cycles, contrasting the two types of contracts:

Economic Differences:

Monetary Irregular Deposit: 1. Present Goods are not exchanged for future goods. 2. There is complete, continuous availability in favour of the depositor. 3. There is no interest, since present goods are not exchanged for future goods.

Monetary Loan: 1. Present goods are exchanged for future goods. 2. Full availability is transferred from lender to borrower. 3. There is interest, since present foods are exchanged for future goods.

Legal Differences:

Monetary Irregular Deposit: 1. The essential element (and the depositor's main motivation) is the custody or safekeeping of the tantundum [deposit]. 2. There is no term for returning the money, but rather the contract is "on demand." 3. The depositary's obligation is to keep the tantundum available to the depositor at all times (100 percent cash reserve).

Monetary Loan: 1. The essential element is the transfer of availability of the present goods to the borrower. 2. The contract requires the establishment of a term for the return of the loan and calculation and payment of interest. 3. The borrower's obligation is to return the tantundem at the end of the term and to pay the agreed-upon interest.

Similar to a monetary irregular deposit would be the storage of crude oil in large tanks. The depositor of the oil pays the storage company a fee. The storage company cannot now go out and sell the oil - that would breach their contract.

Time and time again, throughout history, bankers have attempted to turn monetary irregular deposits into monetary loans in order to speculate with their customer's deposits. Throughout history, from Ancient Greece to the early 20th century it has been determined in courts of law that this practice is illegal. We have institutionalized it. We have created all sorts of fancy schemes in order to cover up this misappropriation (think FDIC). And we have central banks who attempt to mandate positive inflation which encourages depositors to seek return rather than safety with their life savings.

We need a banking system that clearly separates the two kinds of contracts: Depositary Institutions and Loan Intermediaries. With such a system, the central bank's ability to perpetually inflate will be castrated and a truly free-market would be able to prosper (something we have never had). Note that this does not require a gold standard for discipline. A currency could be denominated in anything so long as the legal principles of the monetary irregular deposit were upheld.


To elaborate on the last point. I am not in favour of a legislated gold standard. Although I do believe gold would have a role to play as a medium of exchange if it were permitted (ie. if legal tender laws were repealed). Many of gold's detractors fail to discriminate between Gold Exchange Standards, Bimetalism and 100% reserve gold standards. The latter has very few historical examples of any length. But this is conjecture. I am in favour of multiple competitive currencies which may be freely exchanged electronically, provided 100% reserves are kept and available at any time. There is no reason, with our current technology, for this to be prohibitively complicated. I walk into a bakery to buy a loaf of bread. I elect to pay at the cashier from my account with wheat. If the baker doesn't want wheat, he can program his account to immediately convert wheat to gold or land or whatever she chooses. The intermediary charges a small fee each time this occurs.

Separately, other intermediaries may provide participants the ability to borrow from others who are in the market to lend. Rates would vary according to the risk taken and a term would be agreed upon prior to the transaction completed.

Some Austrians argue that this would effectively end the business cycle. I disagree. There would still be a very noticeable boom/bust cycle because entrepreneurs will always display a herding behaviour and fail regularly. However, the busts would not be systemically jeopardizing due to the lack of leverage. Banks would be mere service providers, not permitted to speculate themselves. Thus, their ability to create loans prior to finding lenders, essentially playing arbitrage on current asset prices vs. inflation adjusted asset prices, will be nixed.

The giant vampire squid's blood funnel would be cut off.

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Anonymous said...

This is the most sensible post I've seen on this subject in a long while. Thank you.

John Cooper said...

I agree with anonymous. Great job, Phil!

John Cooper said...

...um, make that Matt.

Namke von Federlein said...

I second Anonymous.


mike.montchalin said...

Since I understand fractional reserve banking, and since I understand the FDIC is broke (or near broke), and since banks have a really hard time paying out more than $5k at any moment, it is probably a really bad idea having more than $5k in any one bank account.

Also, I am having a hard time figuring out what to do with dollars...

mannfm11 said...

The question is, who do you want to create money and how? What the banking system does is take a fixed amount of money, create more on the base and add interest to it. This creates an immediate insolvable problem and transfers ownership of the money supplies to the banks. The bank is always deficient to pay its liabilities, while it has the force of law (bank and bench have the same meaning)to collect. The repeated story has been they put the money in the banks, why aren't they lending. They aren't lending because they owe more money than they possess and need to deleverage.

I do believe that the end of FRB would make bubbles difficult. It would also slow business expansion and narrow the discrepancy between rich and middle class. At the same time, it would make it really difficult to get money so there would be a lot of borderline poor. There are people like Martin Armstrong that contend that the concentration of capital is needed to have a modern society and he is likely right. The right thing would likely be a system where the government owned most of the profits in a banking system,namely because of the missing interest. There are a lot of holes in modern financial society that need to be fixed. Can the younger side of society really support the capital accumulation and return necessary to support modern people in retirement and medical care for 15 to 25 years? Can the support not only the amounts someone must carry into retirement, but the accumulations leading up to retirment, namely the 45 to 65 years where much money must be saved. Without a real rate of interest, retirement gets difficult. IN the end, a system based on FRB probably cannot be supported.

mike.montchalin said...

Mood-based herding bubbles are one thing. Bubbles resulting from false price signals generated from the fictitious capital of fractional reserve banking is another.

The capital concentration necessary for modern commerce can be generated through stock sales.

Once one understands the risks of fractional reserve banking, it seems that it is actually an un-insurable practice in the long run. Now it is becoming obvious that fractional reserve banking is uninsure-able as the FDIC goes a-searching for funds.

Mark said...

I don't agree that any of this makes FRB a fraud. Under the current system a bank has perfectly reasonable expectation of meeting redemption requests so long as their lending is sound, since they can sell assets if need be. It's the fact lending has not been sound that is the problem, and that is where the fraud lies.

However I do think your distinction between these two contracts is the clearest I've seen.

I suspect if your distinction was enforced by law, almost all savings would be kept as a "Monetary Loan". Just compare the amount of cash in safes to the amount of money market balances, even though the risk if loss is explicit.

People would still demand from their government that deposit takers maintain proper capital reserves against risk of loss, some cash on hand for redemptions, and that lending be regulated to ensure the value of the assets backing their deposits is sound, and as a last resort that they are insured by something like the FDIC. None of the problems inherent in credit would magically go away.

mike.montchalin said...


The Federal Reserve regulates banks' reserve ratios. Small banks have a 0% reserve ratio requirement.

The "Federal Reserve" is not federal. Should the FED be the regulators of reserves? Should the Federal Government? Or should depositors regulate reserve ratios through their market choices acting upon honestly transparent banking disclosure?

Once it was pointed out to me that there is a difference between an irregular deposit and a monetary loan,.... combined with the fact that two parties can not claim absolute ownership of a single item, the fraud of fractional reserve banking becomes obvious.

Once banks make it clear that they are fractional and depositors are made to understand that their deposits are more at risk than if they had loaned their bucks to their neighbor, then a fractional bank is no longer fraudulent. Disclosure absolves.

RRB said...

I think its pretty easy to resolve any issues of fraud in fractional reserve banking by adopting the following simple steps:
1. Let failing banks fail, allow the market to pick winners and losers. There are plenty of people who are willing to risk funding a fractional reserve bank.
2. Transparency in accounting for individual banks, as well as the Fed, so that the market can get accurate price signals.
3. Repeal of legal tender laws, so that people can use alternate currencies if they want to.

THIS would be a true market solution. Most others proposed here (including abolishing the Fed) are NOT market solutions. Allow the market to weed out the Fed if it wants, and keep it if it wants.

I would say the legal tender laws are the single most onerous provision blurring price forecasts, and hence market efficiency.

Matt Stiles said...

I have nothing wrong with fiat currencies. So long as they are not mandated. In my opinion, numerous forms of fiat currency would spontaneously arise in a market economy side by side with hard currencies of different sorts. The best ones would survive. The weak would fail.

Anonymous said...

Note that this does not require a gold standard for discipline

This is what I've argued with goldbugs for ages - the real issues are to do with fractional reserve lending and with floating vs fixed exchange rates - which would still be issues regardless of whether gold even existed or not.

I disagree with revoking legal tender though. Such a thing would be waaaay too confusing to the average person to be practical. How would one fight counterfeiting and fraud with multiple currencies? It would be a nightmare for a small retailer.

Also, it would probably impossible so long as there are sales taxes.

I see nothing wrong with people freely bartering however they choose but there really should be *one* thing that should be legally enforceable and in that regard the current system appears to work just fine.

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