Fr. Coughlin placed much emphasis on the “private ownership” of the Federal Reserve System, but it is surely an unusual “private” organization whose officers are all appointed by the federal government and which was established by an act of Congress. A far more significant and substantive critique of the Federal Reserve would involve its ability to create money out of thin air, its dilution of the value of our currency, and its responsibility for the business cycle. On these fundamental issues, Fr. Coughlin was in lockstep with the Federal Reserve – he simply wanted the federal government, rather than the Federal Reserve, to do the inflating. How is this a sweeping critique? FULL ARTICLE
Source link: http://blog.mises.org/3771/fr-coughlin-and-friends/
Fr. Coughlin and Friends
Previous post: Quarterly Journal of Austrian Economics 8, no. 1 (Spring 2005)
Next post: What’s Behind the Trade Deficit Numbers?
{ 37 comments }
There is nothing specifically wrong with “fractional reserve banking” except the labeling. If you own a mutual fund, it is much the same – they take your money and invest it. Banks do the same, but typically at a local level – they write mortgages for locals or give business loans.
But if you look at the fine print for the mutual fund, you can see they have the right to suspend redemptions, so there can be no equivalent of a “run on a bank”. Most people ignore the provision, but I think the 1997 Asian meltdown day it was brought into force.
If the banks say “we will keep your money in the vault and charge rent for our secure storage”, it is acceptable. If they say “we will use your deposit to make loans to others, but if you want your money back, it is subject to availablity”, it would also be fine. Instead they advertise the former while doing the latter.
Meanwhile, some mutual funds allow writing cheques against your balance. The distinction between a bank and a mutual fund is disappearing.
We would not have to end Fractional Reserve banking per se, just pass a law getting rid of the FDIC and correcting the labeling after some well known date so the “banks” would simply be mutual fund families with local offices that handled cash. But the deposits couldn’t be guaranteed to be withdrawn at any time.
A full gold standard would have kept everyone honest, and would have mitigated the late ’20s bubble (so the depression would have been less severe). That would be an ideal, but it is difficult to propose – during the bubble they don’t want it deflated, and during the bust they wan’t to appear to help the poor. Generally people only get serious about living healthy lives with proper nutrition and exercise after a heart attack – prior to that they usually look for pills or other rememdies so that they can have their excesses but try to put off the unhealthy side-effects.
In defense of Coughlin and inflation, if inflation simply gave every person an equal number of new dollars, it would benefit the poor, as they would have smaller savings to shrink – Someone with $100 that loses 1/4 the purchasing power but gets $100 to make it up is ahead of someone who is wealthy with $10,000 and gets the same $100.
The difficulty is that even Priests sometimes forget only Mary was immaculately conceived, so assume that a power or usurpation given to help the poor won’t instead be used corruptly. The entire reason to minimize the areas Government can have any control over is because it will tend toward corruption. Almost every tyranny which has infected the US has been brought in for good reasons or to accomplish a good purpose which was not authorized by the constitution. But shortly afterward the tyrants and usurpers turn it to corruption and evil.
Most every day I create money out of nothing. I must be a Federal Reserve Bank.
It is the ability to create money out of nothing that has kept the economy going for the last 40 years else we would have reverted to a pre WW2 economy with half the people living in poverty.
Tz: According to your first paragraph, we might conclude that there is also nothing wrong with any fraudulent behavior (except that it misleads, and therefore provides an avenue for implicit theft).
The point behind fractional reserve banking is that it boils down to clients taking out a lottery on receiving their own money back. If the true nature of it was clear to banking customers, and there was no tax-payer funded guarantees of these funds, no one would participate. If they did, it would almost certainly imply they had been misled.
Secondly, your defense of inflation is dubious on purely moral and ethical grounds. It suggests that if inflation were successful in stealing from the wealthy, and transferring that wealth to the poor, it would be fine. Does that argument really appeal to you?
Bill: I don’t think you are saying you run a counterfeiting operation most every day are you? The FED does precisely this, and they do not add a single increment of wealth to the economy. There is no connection between an increase in the supply of paper money in an economy and an increase in its productivity and wealth. It’s a crucial distinction.
Another great article, Tom. One point I’d add about Coughlin is his role in helping FDR in 1936 and 1940. Coughlin, with his golden tongue and huge following, had established such an extremist position on the economy throughout the 1930s that FDR was (successfully) able to position himself as a moderate by comparison. This is remarkable when we remember that FDR himself was transforming the economy along Mussolini’s model.
This is a good answer to the assertion that GNP figures or other such numbers should be used to determine how much the fed or government should inflate:
“…both men claimed, for whatever reason, that money should be issued on the basis of the nation’s productive capacity, as measured in estimated national wealth. The fatal flaw in this approach is that this estimate of the nation’s wealth is itself denominated in money. As soon as the money bureaucracy that these men want to establish issues money on the basis of this estimate, the result will be higher prices, and therefore a higher nominal value of the nation’s wealth. This higher figure will then be used to justify another infusion of money…”
When properly labeled, it is no longer fraud. Or to put it in your terms, misleading someone is fraud by definition. I am going into the nature of the fraud. The actual structure of fractional reserve banking is not fundamentally different from that of a typical mutual fund. Unless giving your money to a third party to invest for your for a fee is inherently fraudulent, neither is “fractional reserve banking”. The fraud comes from saying that the money is going to be available.
There are two mutually exclusive statements most banks advertise:
1. You can withdraw your money at any time.
2. We will invest (loan out) your money in order to provide the return we pay you at interest.
Mutual funds have a prospectus which explicitly says No. 1 above is not true. Banks rely on the FDIC to insure such deposits, but by themselves cannot guarantee availability of deposits.
Under a gold standard, someone who created money was called a mint and required miners. Currently, they are called “counterfeiters”. Though some are legally allowed to counterfeit or embezzle (edit bookkeeping entries).
I did not intend to defend inflation, only the good but naive Father Coughlin (I want to say “Hi, I’m Chucky, do you want to pray?” since he thought economics would be “Child’s Play”). If you could inflate in the manner I said, it would redistribute wealth, and would probably be a lesser evil than the current tax and regulatory system. However that will never happen. The newly printed money (that has not been diluted) will be given to the friends of the corrupt government, not the poor, or everyone equally.
I don’t endorse inflation, even in what might be emergencies (even Heinlein’s “The Moon is a harsh Mistress” has the nascent free country inflating to pay for the government). But I was thinking Coughlin might have assumed inflation would take the track I proposed – disproportionately robbing the rich at a time when the poor were near starvation. But I can’t think of an example where it did not rob the poor at the expense of the rich.
Like many idealistic proposals, it doesn’t work in practice. Coughlin was not stupid and would not have suggested inflation if he knew how it always ends up working – so I was just trying to think why or how he was thinking it might work so I could find the fundamental flaw in the reasoning even at a pragmatic level.
Thanks Tz. I follow you now with your point on inflation.
With respect to FRB, it brings to mind an article i read by Rothbard on the definition of money. He argued that checking accounts are money because people understand them to be immediately redeemable, and in contrast, checkable mutual fund money market accounts were not money because even though they were checkable, the customers understood them to not necessarily be immediately redeemable. His point seems relevant to this discussion.
As long as people continue to view a checking account as immediately redeemable, and hence part of the money supply, FRB would remain fraudulent. That’s where the dispute probably lies: can a label be relied on to make it clear to people that when they “deposit” their money in a checking account that they are actually investing in a checkable money market account, without renaming it as such. Abolishing checking accounts not marketed as money market funds would do the trick i suppose.
Billwald, you make a very Keynsian error in equating numeric value with economic value.
One ounce of silver and one ounce of gold are the same, right? One ounce? Yet their values economically are substantially different. An ounce of plutonium more different still.
On a gold standard there would not be “less wealth, everyone living in poverty”, because although the quantity of gold is not variable, like the quantity of dollar bills, gold is divisible. Deflation means each monetary unit is more valuable, which was the rule during the gold standard.
Which means that just because someone’s income was what you consider “low” does not mean they lived in poverty. Right now I earn three times what my father did at my age, yet I cannot purchase what he did. I am far more poor than he even though my dollar income is so much higher.
So much for your “money from nothing” idiocy.
tz -
I seem to be misunderstanding the concept of FRB here – perhaps you can help. I thought the fraud was not so much in the fact that the depositors money was lent out and therefore not available despite claims to the contrary, but rather that under FRB the deposits allowed creation of new money from nothing by the bank. This newly minted pseudo-money then enters the economy but is fraudulent because it is not backed by any deposit.
FRBs don’t actually “create” new money, but they put existing money which should be locked tightly behind vault doors into circulation increasing the Velocity or the amount in circulation artifically. You think you “own” all that money, but it is actually being leased without your notice.
If you left your car with a shop, and they disconnected the odometer for a weekend road trip, yet did the work and you got the car back – you would probably mind (especially if they wrecked the car and had to explain things). Car rental agencies might be able to enter a new line of business – “garage” cars for people going on trips or who don’t drive them during fixed periods, but rent them out. That would not increase the number of cars, but would the total mileage and traffic on the roads.
Paul Edwards above brings out a good point, but I don’t know if someone’s understanding actually affects things if it doesn’t change their behavior. In one sense the housing bubble exists because people assume they can sell an inflated house with minimal delay.
A money market check could be done even if there was no liquid cash available if the MF had a line of credit they could use to meet the demand – but then they would need to charge interest, and you could have an overdraft even if you had enough in assets to cover things.
A check would then be you writing yourself a loan up to the value of the collateral (the securities in the account). Normally only liquid mutual funds (e.g. money market or short term treasury) will allow check writing. And there are limits since it costs money to process them – typically the checks have to be above a certain amount.
“What people understand” is a problem as too many people are fools, me included. I was listening to a pair of mortgage lenders talking about investing (ironically on Michigan Catholic Radio – who has inherited Coughlin’s microphone since they host some of their religious programming from his old studio – though not this program). They implied unemployment was at a trough (though the GM and Ford announced layoffs haven’t occured yet), real estate always goes up, talked about zero-down mortgages so you would get all the appreciation, etc. I wrote a post contra these bubbleheads, but a lot of people will “understand” houses are not really different than stocks, except you need a real-estate agent instead of a stockbroker to buy and sell.
What people “understand” about their checking accounts and what they really represent can be very different things. And it usually requires a few burned fingers for the population to learn as a whole that some things are hot.
TW:
Unless I missed it in the reading of your good and enlightening article, you did not make the distinction that most make in comparing private and govt. monoploy in issuing money: private notes are always interest bearing; presumably a straight govt. system, at least as proposed by those who favor it, would involve no interest. We are coasting $9 trillion in debt of the “people” to somebody or other (not me, I receive no interest payments); and that seems an enormity that calls out for redress. I can’t imagine how we will avoid a repudiation of some sort somtime. As for the 100% gold system, I retain the reservation that it apparently has never worked; the holders of gold (bankers) always cheat. That leads to the feeling you cite that the fractional reserve system has some things to be said in its favor. A last point: if anyone at all lends gold at interest—and in a straight gold system expects to be paid gold in return—in the end—in time—all gold will end up in their hands. Einstein is said to have said that compouond interest is the most powerful force in the universe. Leave a bit of gold out at 6% interest compounding and eventually it will require a ball of gold bigger than the earth to repay, etc., etc. I think it interesting, that the old Israelites and the early scholastics (and Aristotle) all thought interest-taking very wicked. Will this whole thing ever get settled in the squid-ink ambience we live in? Tom White
If I remember right, Coughlin got his way since FDR said he didn’t want to devalue Gold, but only did so after the constant harranging coming from Coughlin.
It was inflationary, but it was equally asymmetric, as it affected those who held gold, which few very poor people did. It was also blatant theft since it was a confiscation. But this one thing actually did the robin hood effect correctly (instead of compensating the poverty pimps instead of the poor as the usual program does).
No, I won’t defend it, especially since it wasn’t even inflation but confiscation. But would note that the disparity of the effect was toward the angle Coughlin would have wanted.
Gold tends to have a very small interest rate as there is no inflation risk. 6% might be loansharking, but would represent a large risk premium for default, so would return to the 1%. A little gold is mined each year, some ends up as jewelry. The value or supply of gold isn’t really fixed – when it becomes more valuable (even in ancient times when famines hit), jewelry becomes money. When it becomes less, fewer go to mine it.
Sometimes it just deflates so becomes more valuable by sitting there, but that would be silly. Money represents power to meet needs and then wants. I suppose some would like to sit on a hoard of gold (like the dragon Smaug in the Hobbit), but most prefer spending or giving to charity or accomplishing something with it.
Usury was a sin against charity – a typical example would be to loan someone money to pay for a required medical procedure, then throw them in jail if they could not pay the debt. Investing – putting money at your (as opposed to the debtor’s) risk for a return is a different thing.
The bankers can only cheat on a gold standard if the government allows them by defining fraud to exclude their leasing out of the gold you deposit while they claim it is in storage for you. Today there are commodity warehouses that will hold gold, silver, or other things with serial numbers and linked to your name (and you can normally arrange an inspection). This is nonfungable storage. Some also have fungible storage where they are supposed to keep all the gold in a big pile, but you might not get back the specific bar you deposited, but would get the same amount of gold.
The fact it works today means we could have it tomorrow for a gold standard.
Hi Gekko:
Is FRBing fraudulent because
1. the depositor’s money was lent out and therefore not available despite claims to the contrary
2. under FRB the deposits allowed creation of new money from nothing by the bank.
In my opinion, the answer is Yes. Rothbard describes FRBing superbly, but let me take a quick crack at it:
1. You deposit $100 in your checking account at the bank. The bank now has an asset of $100 cash (its reserve), and a liability of $100 as a checkable demand deposit to you.
2. The bank, therefore lends out $90 based on your deposit, leaving itself with the above asset/liability, plus a new asset of a $90 IOU from Joe borrower, and an additional liability of $90 as a checkable demand deposit to Joe. This new $90 demand deposit is the newly created money from nothing. That is where it all begins.
Say Joe, who borrowed the $90 to spend it, spends it. The bank now has an asset of $10 cash (its reserve), an asset of $90 IOU from Joe, and a liability of $100 as a checkable demand deposit to you. You have a checking account that says you can cash $100 of your own money at your whim. The bank, on the other hand, has precisely $10 to cover that liability. Hence, problem 1 is true. The initial loan of the $90 to Joe made 2 true.
Tz: I agree with your comment wholeheartedly: “What people “understand” about their checking accounts and what they really represent can be very different things. And it usually requires a few burned fingers for the population to learn as a whole that some things are hot.” This is why it’s a strain for me to imagine a world where fractional reserve banking could realistically avoid being fraudulent. The banks would always have an incentive to mislead, and the term “deposit” is already a misleading term in connection with banking because it implies a warehouse concept, where you deposit your money for safe-keeping.
My garage moonlighting as rental car supplier is my counter to the “increase in the money supply”. The bank cannot “create” money, but it can take money that it (falsely) says is held in reserve and put it into circulation. As long as too many people don’t want to drive their cars off schedule, the system works.
My point is that point 2 – “creation of new money” is technically wrong as no new money is created, no more than cars are created in the garage, or to go back to the original form of the fraud, the goldsmiths with gold on deposit didn’t create gold when they loaned out a percentage of what was deposited.
However PQ=MV and the other equations tell us that playing with V can be as dangerous as playing with M, and tends to have the same bad effects. Worse, demanding deposits tends to shrink V a lot more than M – you could take printed money for people’s mattresses, but it won’t circulate (Irving Weiss noted this in the early 1930′s – the money supply was going up but it wasn’t circulating).
It might just be a subtle difference, but “creation of new money” is different from “increasing the money in circulation”.
The mutual fund industry has the same exact incentives as the FracBanks, and that is probably whey they put the notes about suspending redemptions in microfiche sized type. Or even the market – they assume you can always sell. But sometimes there are no bids (as in 1987, or as LTCM found out and I think a lot of rocket scientist hedge funds are about to go ballistic).
The happy talk – tune into CNBC (the only bubble they can see is Oil over $50) inspires optimism. Is that “fraud”? I don’t think so, either morally or legally. Risk is difficult to measure, and usually the opinion has more to do with the emotion of the measurer than objective standards.
And there is the effect Hyman Minsky describes where stability breeds instability – careful FRBs won’t go bust since they will have high standards and reserves – but others who take greater risks will make greater profits for a while. This continues, but some of the risk is collective and things eventually collapse taking out much of the good as well as the bad. But people want safety only after a bust, and want to get 10% per year or more during a boom. If FRBs aren’t allowed do it (inflate bubbles), other institutions will.
The problem is not that there won’t be safe banks – I gave the example of warehouse/depositories. But they aren’t patronized. For a percent or two more, people will move to riskier places. Foolish optimism is not fraud – if it was it would be easier to fix.
Hi tz: I understand what you are trying to say with “the banks don’t create money”. What they do is create claims against money that does not exist, just like the gold-smiths created claims against gold that did not exist. The point, however is that people treat their checking accounts as money. In my example, which is basically Rothbard’s, both the depositor and Joe the borrower considered themselves to be in possession of, in total $190, whereas before the credit expansion, there was only $100. Unless you are saying that checking accounts don’t constitute part of the money supply, i think you will have to agree that the banks are creating money each time they lend it out via a credit expansion.
In regard to the formula PQ=MV, i am dubious of its utility and Rothbard refers to its use, in MES, as leading to “…a tangle of fallacy and irrelevance”.
Banks do not claim that all the funds deposited are stored. They openly admit to lending out nearly all the funds deposited. Go ask you bank. Find your banks’ balance sheet on the web.
If you want your money stored at a bank, you rent a safety deposit box and store cash right there. As far as I know, no bank is accused of opening the safety deposit boxes and lending out or renting the contents.
Every college economics course and money and banking course explains that banks don’t keep deposited funds in storage. They also describe the consequences of fractional reserve banking on the total money supply.
The banks do promise to pay off depositors on demand. But that doesn’t imply that the banks store the funds. It does imply that there is a risk that the bank will be unable to pay off as promised.
The notion that the bank must be certain to be able to pay off, say by storing the money, is absurd.
If someone borrows money and promises to pay it back in a year, there is no way that person can be certain that they will be able to pay the money back. If they borrow the money with no intention of paying it back, then that would be fraud. But, generally, people borrow with the intention and the probability of paying the money back on time. But not the certainty. There is risk.
When banks borrow money promising to pay you back whenever you want the money, they believe that they can carry out that promise. Sure, things could go wrong. When they loan the money out, maybe it won’t be paid off. Or, maybe too many people will want to withdraw their money at once. There are risks. But the bank intends to pay off everyone who asks. And they generally are able to do it. They probably can pay off everyone who actually asks to be paid off. But there is a risk.
Again, there is no way that any borrower can believe that they will certainly be able to pay back the money they borrowed.
Suppose a bank borrows money for six months and then lends it out for a year. Does that mean that the bank commits fraud? No, the bank can intend to borrow more money to pay off the first money it borrowed, and then pay that money off when it collects on the loan it made. If necessary, the bank could sell the loan it made to get the funds to pay of the money it borrowed. Sure, there is a risk that this won’t work out and the bank won’t be able to pay off the first loan. But there is always a risk.
Now, suppose the bank borrows money for one month rather than six months. Or one week? Or one day? Or one hour? Or one minute? Or one second? Or one microsecond?
Suppose the bank borrows the money for one day, but tells the lender that they don’t have to collect right away. They can collect whenever they want?
The notion that a bank promising to pay back money whenever the lender wants it is promising to store the money is absurd. If banks want to promise to store money, why not just say, “we will store you money for you.”
Now, fractional reserve banking does increase the money supply, or, if you prefer, reduces the demand for base, or high powered money. These consequences of fractional reserve banking might have bad consequences for the economy–inflation or a boom that must be reversed. (Maybe.)
If fractional reserve banking causes problems, then perhaps it should be banned and banks required to maintain 100% reserves. It would be an intervention for the public good.
But it is time to give up on the fantasy that fractional reserve banking is fraud.
Oh, by the way, there are many people who know about fractional reserve banking and still keep their money in banks. Before FDIC or the Federal Reserve, there were plenty of people who understood that banks lent out most deposited funds and still kept their money in banks.
The notion that people would quit using banks if they understood that banks keep only fractional reserves is simply false. People don’t want to pay storage fees for 100% reserve banking. They like earning interest on money they can collect on demand. They are willing to accept some risk to avoid the fees and collect the interest.
Fractional reserve banking as fraud is an embarrassment.
As I’ve noted – what you describe for a bank seems true for a mutual fund, except with explicit disclosure. That is why I don’t think it is a fraud (and note the specific distortion with loaning out deposits), just a mislabeling. Relabel banks mutual funds tomorrow and little will change except truth in labeling.
While there is nothing wrong with checkable mutual funds, if that is what people want, a demand deposit isn’t the same thing. With a mutual fund, any loss is divvied up among the fund shareholders. With a standard deposit account, losses are suffered by stockholders up to the amount of capital they have built up in the bank. If the losses are so large that the stockholders’ capital is wiped out, then any remaining losses are suffered by the depositors. And, of course, the losses only get divvied up among the depositors after the bank is liquidated.
From the point of view of the depositor, a conventional deposit account is safer because the stockholders’ capital provides a cushion. On the other hand, if that capital is wiped out and the bank fails, the standard deposit account is less liquid, because whatever money they have left is only distributed after the legal process of liquidation. Mutual funds have the advantage of quickly and rapidly shifting any losses to the “depositors.”
Another way to put it is that the standard deposit account works better for depositors when the financial institution’s asset portfolio takes relatively small losses. It doesn’t work so well when things go really bad.
Advocates of free banking (like me) believe that depositors should be free to choose. Financial institutions should be free to organize their operations as they choose. Generally, we find these charges of “fraud” against one particular form of organization to be mistaken.
I wouldn’t really care if banks that promises to pay off on demand were required to disclose a policy of not keeping 100% reserves. On the other hand, I don’t believe that promises to pay off on demand means that they are promising to keep 100% reserves. My own view is that banks that want to keep 100% reserves should state that such is their policy and should be held to it. People who want to keep their money in 100% reserve banks should patronize such banks and pay the fees necessary. But again, it doesn’t really matter much to me what the rule for disclosure might be.
I completely the reject the notion that fractional reserve banking is fraud even if the policy is disclosed to customers. And the prediction that no one would patronize such banks is surely false. They have many times in the past.
Money should be a commodity – index currencies do not work and where there is more than one commodity (say gold and silver) expressed in the same tems (treated as if they were the same currencey) then one will drive the other out of ciruclation as conditions change over time. Unless the commodities are allowed to have a free exchange rates (in which case we have more than one currency – as, for example, the Kingdom of Hanover had in the early 19th century).
Whatever commodity is treated as the currency of an area (i.e. whatever people choose to use)banknotes issued claiming to be backed by this commodity must really be backed by it.
In the 19th century banks repeatedly issued more notes, cheques and drafts (and so on and so on) than they had gold to back it.
It would not have mattered had silver been the main currency or any other commodity. The problem is that it is always tempting to pretend to have more than you have got.
Talk of “labels” misses this.
No bank wants to say “accept our notes, we do not have the commodity to back them – but accept them anyway”.
Hence all the complex double talk.
Also this explains the endless bankruptcies and demands for government bailouts.
Acutally one may not need to outlaw fractional reserve banking. Just make it very clear that no person who deals with such a bank will be compenstated if the bank fails. Then the problem will take care of itself – in time.
It is government efforts to stimulate banking and prop it up that cause the most important damage.
As for the modern world – where Federal Reserve Notes are not even backed by false claims. Well we have fiat money – money by command, pay your taxes in this or else money.
In the 1920′s the financial system had big problems. Fractional reserve banks encouraged by a Federal Reserve Board that issued credit which it did not have the gold to back (at the exchange rate it claimed for the Dollar) – now the financial system does not have big problems, it is one big problem itself.
It is based on nothing apart from threats, and is just an accident wainting to happen.
I suppose the Federal Reserve Board – government could get divide the gold they do hold by the number of Dollars in circulation or in financial institutions (mostly computer credit) and come up with a true exchange rate for the Dollar.
My guess is that it would be a tiny ammount of gold, but at least they could say they are backing the money with something. And (most importantly) stop inflating.
Three of several issues that I have with free banking are (briefly) as follows. First, a basic principle of finance is that the time structure of the liabilities of a business should match the time structure of its assets. This principle would not necessarily be adhered to under free banking. Second, under a free banking framework that utilizes fractional reserve banking, I would concede that if the notes and/or demand deposits clearly state that they may not at all times be redeemable on demand at face value this probably would not constitute fraud. I would argue, however, that the notes of these banks would not circulate, trade at face value; the market would impute a discount to these notes to reflect the possibility of their not at all times being redeemable at face value. Finally, there is the issue of Austrian business cycle theory. If free banking involves the creation by banks of loanable funds that are not the result of previous real savings, then this framework will contribute to the business cycle, as it is understood by Mises.
There are some good arguments being made here about why FRB isn’t or is fraudulent, with all cases of fraud the extent off disclosure is important. If they disclose the fact that the money you deposited will be lend out again, and thus might not be redeemable, then the client is well aware off the activities of the bank. This is full-disclosure and thus there can’t be any fraud. But this is the disclosure of a 100% reserve bank, or a money-warehouse that’s now also functions as a S&L bank. In this case the money is practically lend out for you through the bank, but FRB goes further than that. The disclosure of a FRB bank would be: Were going to take your deposited money and lend the same amount out not 1 time but 10 times, so you’re money maybe not redeemable. The banks also have to disclose the consequences of the procedure of lending out 9 times the amount(unbacked) deposited. Because the client suffers indirect from lower purchasing power, business cycles etc.. When the bank discloses all the consequences of inflation then no one can sue for damages on the basis of fraud, because the bank was clear in its intentions. In this situation FRB wouldn’t be fraud, but this isn’t the case in current bank policy. Till this is the case FRB remains fraudulent in my opinion. With fraud being the misinformation by someone causing direct or indirect damages to other parties.
Dennis and Maikel both make excellent points. And Maikel’s argument reminds me of one further difficulty in eliminating fraud from FR lending. As he puts it “Because the client suffers indirect[ly] from lower purchasing power, business cycles etc.. When the bank discloses all the consequences of inflation then no one can sue for damages on the basis of fraud, because the bank was clear in its intentions.” However, pursuing further the above reasoning, how do the bank and its depositors and its borrowers avoid defrauding the man who earned his bank-notes fairly through his efforts, and yet, does not deposit them with any bank? How is he protected from the harm done by the agreements between others that we know certainly will steal his purchasing power of both his current cash holdings, and further earnings?
I think you hit one of the key points with FRB fraud. Usually the damgage is done to the missinformed by the missinformer. But in this case of FRB half of society suvers damgages, while just 1 contract was signed. This is indeed a difficult situation. We know for sure that the bank is fraudulent against the depositor(when not fully disclosed), but what of commiting fraud against all the others. If we use my former definition, we see that the “others” were not misinformed, but are just suffering damages beacause of the direct actions of the bank. I don’t think this can be called fraud, but it’s definitely another criminal act. This is deep water, so if someone else would shine a light on it I would be pleased.
Matching maturities reduces risk. But there is no rule of finance that says that risk should be zero.
It is possible to borrow short and lend long, or to borrow long and lend short. Changes in interest rates will result in gains or losses. There is risk. It is called interest rate risk.
There is no rule of finance that claims that any risk must be zero, must less interest rate risk.
(What is a rule of finance? A rule of thumb, an economic law, or a government regulation? There may be a rule of thumb that maturies should be always matched–a very conservative rule. But it isn’t an economic law or a government regulation.)
It is false to say that a fractional reserve institution lends out money multiple times. Such a bank lends out no more (and usually less) than the amount deposited.
It is true, of course, that funds that are lent out may well be deposited in some bank. There is a rather mechanical “model” of the process that shows a multipication of deposits. But no bank is leanding out a multiple of its deposits. Each individual bank must match deposits and loans.
If this all has bad effects on the economy, that doesn’t make it fraud. I don’t really agree that the effects are all that bad, but regardless, it isn’t fraud.
That would be like requiring pornographers to disclose that some people think that the spread of pornography will corrupt society. That it is somehow fraud to sell pornography without disclosing some people’s theories that it has bad effects on society at large.
If someone chooses to reduce his or her gold holdings, that reduces the demand for gold and the purchasing power of gold. Is this “fraud” on all the other people who own gold?
People can use fiduciary media as a medium of exchange if they want (aside from government regulation.) To the degree they choose to use fiduciary media as a medium of exchange in place of commodity money, that reduces the demand for the commodity money. This reduces the purchasing power of commodity money (and the fiduciary media too, since its value is tied by redeemability to the commodity money.) There is nothing wrong with that. It’s like claiming that if someone starts selling cubic zirconium jewelry, and lots of people start wearing it instead of diamonds, and so diamonds lose value, all diamond owners have been cheated. No, they haven’t been cheated until or unless someone tries to sell them cubic zirconium jewelry as a diamond.
You have no right to have everyone else continue to demand as much gold as they have in the past so that the value of your gold holdings don’t fall. If they find something they like better than gold (say, silver jewelry) you have no right to claim that somehow the silver mining interests have cheated you by meeting other people’s new preference.
Bank liabilites–notes and checkable deposits–can take the place of gold for use as money. They aren’t risk free for those using them. There are various types of risk associated with using them. They involve borrowing short and lending long–so there is interest rate risk. There is also credit risk. The banks’ capital protects depositors against that risk to a degree, but not completely, because a bank can fail. So, there is a risk for the depositor.
But people have the right to decide whether they want to use that sort of instrument as money or else want to pay storage fees and use warehouse receipts. Or carry about gold coins or bars.
It is their choice. And using ordinary banknotes or checkable deposits (with the banks holding whatever gold reserves they find appropriate) isn’t fraud unless banks claim that they are storing gold.
Most libertarians believe fraud should be illegal. Some libertarians believe that fractional reserve banking has bad consequences. Rather than just admit that they want to make it illegal to avoid these bad consequences, they pretend it is fraud so that they can make it illegal while pretending to be a perfectly consistent libertarian.
Isn’t that a lot more plausible than pretending that people believe that banks are just storing money? Or that no one would use banks if they knew there was a risk that they would take a loss if the bank failed? Or that failure to disclose what some people think are the bad social consequences of banking is somehow fraud?
One final point. The ordinary worker who receives a banknote and doesn’t want to bear the risk can redeem it. And if they are worried about the ability to redeem it, then just don’t accept it.
I think implicit theft is fraud. In this case, the fed itself is the culprit.
Hi Bill: “It is true, of course, that funds that are lent out may well be deposited in some bank. There is a rather mechanical “model” of the process that shows a multipication of deposits.”
This “rather mechanical” model accurately reflects the reality of the multiplier effect, or would you not agree? It’s an interesting exercise just to step through this process to get the hang of it. It’s brilliant.
Regarding: “But no bank is leanding out a multiple of its deposits”, the point is that the banks collectively do pyramid deposits by a factor of 10, the inverse of the reserve ratio (1/.10 = 10) times their collective reserves.
As for “Each individual bank must match deposits and loans”, this matching is the coolest of miraculous book-keeping techniques: Where there was no entry on either side of the Asset/Liabilities sheet before, all of a sudden there is an IOU from the borrower on the Assets, and a brand spanking new corresponding demand deposit to the borrower under liabilities. If only us non-bankers had such creative freedom to alter our own personal finances!
Of course there is a multiplier effect, if there wasn’t then banks would lend out equally the amount that is deposited. But that would be a 100% standard. The very essence of FRB is that the bank use only a small amount of reserves to lend out more “money”, hence the name Fractional Reserve Banking. But this is elementary banking theory, beautifully described by Rothbard in “mystery of banking”. What as for the bad consequences of “some theory”, well it is basic economic reasoning that if you supply more of something, the price will fall. In this case the purchasing power. I look at the whole problem of FRB from an Austrian point of view, because I consider it to be THE theory. If you follow a different theory or perhaps see no damages being inflicted by FRB than you’re going to get at another conclusion. But in my opinion following the theory of money described by Mised and Rothbard, FRB will cause certain consequences(described above) and following Rothbard’s “ethics of liberty” FRB is fraud.
I don’t think the money multiplier argument is very good. First of all, it assumes a binding required reserve ratio. Suppose all banks really want to keep less than 10% reserves, but government requires 10% reserves. Then banks actually all keep 10% reserves and you can plausibly do a multiplier analysis.
If banks keep the reserves they like, then each bank keeps a different reserve ratio. Further, it is almost certain that it would change. That is, the point of holding reserves would be for them to be used to meet mismatches beween deposits and withdrawals.
No simple multiplier analysis. You can work with an average, but the average changes depending on how deposits move between banks.
Further, the analysis you are using assumes that all “high powered money” is used solely as reserves.
For example, in a gold standard, if all gold were used as bank reserves, and banks all kept the same reserve ratio, then there would be a muliplier effect as explained in every introductory economics book.
But, in reality, gold is used for many purposes, other than bank reserves. The process of money expansion generated by fractional reserve banking will impact these other demands. Gold coinage, gold jewelry, etc. And so, there is no “multiplier” really. Fractional reserve banking will generally expand the supply of money, but not in some mechanical relationship to the reserve ratio.
It works much better with a fiat currency–assuming the fiat currency is solely used as reserves. But that doesn’t work out either, because the fiat currency is used as hand-to-hand currency, and the amount people want to use is influenced by the money expansion process.
If you assume that people hold a certain fraction of their money in the form of currency, you can still do a multiplier analysis, but why is such a mechanical process plausible? What if currency holding depends on income or the price level?
In reality, the relationship between base money (federal reserve notes and reserve accounts at the fed) and the M1 money supply (currency and checkable deposits against which reserves are held) is 1.7. The required reserve rato is 10%, but rather than creating 10 times as much money as there is currency (and deposits at the Fed) only 1.7 times more money is created. In other words, it isn’t even doubled. Why? Because it is a lot more complicated than the simple money multiplier suggests. There are other sorts of financial instruments that are payable on demand and the grand total of checkable deposits and all of these is a lot. But almost none of them require reserves.
Anyway, the “real” problem with the analysis is the assumption that 100% reserve banking is somehow right and the amount of money generated by that system is somehow right.
Yes, fractional reserve banking general involves a greater money supply than 100% banking. Why is one more “right” than the other? They are just different.
A higher money supply implies a higher price level (cereris paribus.) Why is one price level better than another? Further, in a fiat system, the price level doesn’t necessarily change, fractional reserve banking just “requires” less fiat currency for any given price level.
By the way, the notion that the banking system can create deposits to match loans ignores the fact that people can always demand redemption.
In a fiat system, they can only issue deposits if people prefer deposits to holding fiat currency.
Think about it this way. Suppose we had 100% reserve banking because of government regulation (the usual reason it has existed in the past.) There is a fiat currency system, so the banks are storing fiat currency in their vaults. Now freedom of contract is allowed to reign, and some banks start issuing a new class of deposits. Because people are so propogandized by government that reserves are important, the banks promise to keep 50% reserves but no storage fees and even a little interest payed on the funds.
The result is that the demand for fiat currency falls whenver bank customers switch to the 50% reserve deposits. There could be inflation, but only if the government fails to reduce the supply of its fiat currency to match the decreased demand. The banks are just creating new deposits to match the demand for them. This new kind of deposit doesn’t require as much fiat currency to produce them as before. And so the demand for fiat currency falls. Any inflation is the fault of government for failing to adjust the supply of fiat currency–the instruement it supplies.
In a gold standard, banks can only issue deposits if people prefer holding them to using gold currency or using gold for jewelry. Really, they can only issue deposts (and notes) if people want to hold them. If they don’t, their value will fall relative to gold. Any excess supply of notes or deposits will generate an excess demand for gold (which would raise its price in terms of notes or deposits.) And the excess demand for gold results in redemption, and the excess notes or deposits will be redeemed.
The price level depends on the supply and demand for gold. The demand for gold includes the demand for bank reserves, the demand for gold coins, and various industrial uses, like jewelry.
Under such a system, the supply of money (gold coins, notes, and deposits) at least partly depends on the demand for money. To the degree that people are willing to hold less gold for monetary purposes (either bank reserves or coin,) this reduces the demand for gold and raises the price level. At a higher price level, there is a higher demand for money.
If you want, you can calculate the ratio between the banks gold reserves and the deposits and notes, but this isn’t really what determines the money supply or the price level.
It is conceivable that such a system could operate with no gold coinage and almost no gold reserves. The “reserve ratio” would be about zero. But the money supply wouldn’t be near infinite. The price level wouldn’t be infinite. The remaining industrial demand for gold and supply of gold would still determine the price level. There would be very little or no demand for bank reserves. The supply of money (deposits and notes) would adjust to equal the demand for money.
Now, maybe it would be a bad system. But it is possible. And it shows that the money multiplier analysis doesn’t apply very well to a gold standard. Thinking about that, I don’t really think the money multiplier analysis is very useful ever.
Of course banks issuing checkable deposits or notes create money. It is just that some kind of mechanical relationship between the reserves banks hold (either because of regulation or because they choose to hold them) isn’t very useful in understanding the money supply process.
The only institution that can create money out of thin air is the government, because the fiat currency it issues isn’t redeemable in terms of anything.
Hi Bill: I don’t know. The analysis that arrives at the money multiplier value strikes me as a good basis for an understanding of how the banks and money works. It seems to be sensible in theory, but what you’re saying is: its not very useful or accurate.
As a test, let’s go to the Federal Reserve web site and look at some boring numbers:
It seems the commercial banking industry possess assets to the tune of 8713 billion dollars. Wow. Money honestly earned by somebody I’m sure. At the same time, the Federal Reserve itself has managed to supply banking reserves to the tune of 845.7 billion dollars. So,
From:
L.109 Commercial Banking (1) (p69)
Billions of dollars; amounts outstanding end of period, not seasonally adjusted
Total financial assets: $8713.2B
And from:
H.4.1
Factors Affecting Reserve Balances of Depository Institutions and
Condition Statement of Federal Reserve Banks
Total factors supplying reserve funds: $845,709M
Some crude and simple math:
Commercial Banks total financial assets / Total factors supplying reserve funds
$8713.2B/$845,709M = 10.3
Ten. OK, but that was not with say, MZM, that was Banking assets. Working with MZM, (Money Zero Maturity)
MZM: $6611.718B
$6611.718B / $845,709M = 7.81
I’ve been way off before and maybe I am off here as well. But so far I remain convinced that banking functions just the way as Rothbard describes it.
Bill, I am also curious of your distinction between creating money, and doing so out of thin air. You say “Of course banks issuing checkable deposits or notes create money”, but “The only institution that can create money out of thin air is the government…” I would argue they both create it out of thin air, the only real difference being that the fed can’t be called on its counterfeiting, but the banks (potentially) can (it’s called a bank run).
If you don’t believe in the reserve ratio and FRB creating money and thus extracting the money supply maybe this example will help. If C Bank must hold 10% of all it’s liabilities in reserves, trough government regulation. There reserves are 1000, so total liabilities(demand deposits etc.) are 10000.(if they are fully loaned up). Now trough open- market purchases the fed increases the reserves of C bank with 200. The result of this is that now, the reserve ratio has become 1200/10000 x 100% = 12%. The bank has excess reserves, but since the banks are always trying to be fully loaned up, the will loan out the excess reserves. But with how much? Till the reserve ratio is back to 10%. Since the reserve ratio is 1200, total liabilities will be 1200/0.1 = 12000. Thus an increase in reserves with 200 leads to an increase of 2000, wow 200 is 10% of 2000, that 10% is the reserve ratio. The money supply has increased with 2000 of which 1800 is un backed by reserves. Causes? Loss of purchasing power, lower interest rate(business cycle) you name it. Of course there are natural checks in place so that the bank can’t inflate infinite, one which you described, namely that people don’t have to use bank currency but use gold. This is a free market check and works well, but since the government has legal tender laws in place people must use banks. The second natural check is what Paul just described, the risk of a bank run, when customers lose faith in the solvability of the bank. The last one is not everyone is customer with the same bank, so reserves will be called on by other banks when transactions are made between clients. The banks solve this problem by inflating not with 2000, but by (1-10%) x 200 = 180, this will lead to an increase of 2000 in the aggregate. All of this is explained in “what has government done to our money” and “mystery of banking”. I too believe that money creation is best explained by Rothbard, if you haven’t red these book, you should they should be very insightful for you and they’re relatively short.
I would (and do) say that banks create money out of thin air, however, they are restricted to issue this money only in the amount their customers are willing to hold. The reason is that they are obligated to redeem their money and so its price remains pegged to the redemption medium. The goverment, issuing fiat currency, isn’t obligated to redeem in terms of anything. And so it is not limited to issuing money in the amount those holding it are willing to hold.
Legal tender doesn’t require people to use banks, unless you mean central bank notes. I don’t distinguish between those notes and fiat currency.
As for the figures–there is no doubt that bank reserves are very close to 10% of the amount of checkable deposits against which reserves are required by regulation. But currency plus checkable deposits is not equal to ten times the monetary base, which is currency plus reserve deposits at the Fed. It is 1.7. Most of the financial instruments in MZM aren’t checkable, and further, are not subject to reserve requirements. It is possible to modify the money multiplier to take these factors into account. It “works” economically, if people have preferences regarding the ratios in which they hold these various instruments. It works as a tautology always, but not economically if there is something else determining these relationships. If MZM to base money comes close to 10, then it is just chance, and not empirical evidence for the simple version of the money mulitplier you describe.
the mzm mulitplier is (1 + c + z)/(c+r)
Where c is the ratio of currency to checkable deposits (that have reserve requirements) and z is the ratio of zero-maturity financial instruments to checkable deposits (other things in MZM that have no reserve requirements to the checkable deposits that do have reserve requirements.) And r is the reserve-checkable deposit ratio. That is, the 10% used in your examples.
The c and the z are determined by the preferences of the public. The r is determined by regulation (today.)
You have been assuming that c = 0 and z = 0.
Anyway, any money and banking text will explain all you want to know about reserve requirements and the money multiplier. It will start with the simple relationship found in Rothbard (which I have read,) and then go on from there.
Many economists find it very useful. I certainly still teach it. (There is no need to explain it to me.) But I am not at all certain that it is the best approach. I have already explained why. No doubt, I wasn’t clear enough.
It is thinking about equilibrium in a gold standard that led to my rethinking of the approach. I’m not the first to have doubts.
Most economists don’t care because they aren’t too worried about free banking in the context of a gold standard.
In terms of today’s world, if banks were still doing little else than issue zero-interest checkable deposits subject to reserve requirements and making loans, then I suppose it would be pretty good. But that is only a small part of the banking business today.
That doesn’t mean that banks don’t create money. They do. But if people decided to hold currency instead of bank issued money, then all of the bank issued money would just go away.
If people decided to hold hold rather than government fiat currency, the result would be a higher price of gold. It would make the fiat currency all go away.
Comments on this entry are closed.