Comments (104)

• mark

  I like the example of the $20 bill and the IOU but you missed the opportunity to make the point that the $20 bill is an IOU itself. All paper money started out as an IOU (in the private sector), then banks were nationalised and legal tender was established and finally the government stopped keeping reserves (i.e. it spent them). The fact that the $20 bill has no value unlesss the government stands is surely reason enough to support the government.

  As for government saying:

  "Support us and we will use our guns to siphon off money from the unorganized rabble every year and give you a cut."

  Aside the technical difficulty in using a gun as a syphon - that pretty much happens directly now, with lobbyists supporting incumbents in return for restrictive regulations.

  My only question would be this. Suppose a government wanted to cut tax and spend as a proportion of GDP but did not have sufficient political support to cut spending in real terms (or cut spending by much). Knowing that lower taxes could maintain the desired level of spending, but it would take time for revenues to rise, do you think a short term deficit is acceptable?

  Published: January 16, 2006 8:44 AM

• Stefan Karlsson

  You forgot to deal with two of the more laughable arguments for deficits, both produced by Tom Nugent in this NRO article: balanced budgets (and budget surpluses) causes recessions and budget deficits *increases* savings.

  Published: January 16, 2006 9:30 AM

• Alex MacMillan

  Every dollar of current government spending requires exactly one dollar of taxation to finance it. If the government borrows the funds, the PV of future tax-financed interest payments equal exactly one dollar. Rolling over debt is irrelevant to this truth. Debt-financed government spending, however, pushes the taxes onto future year taxpayers.

  If the current government spending is on consumption-type goods and services, then the current taxpayer group benefits (hopefully), at the expense of future taxpayers. If the current government spending is on investment-type goods (or services, such as R&D, education, etc.), and if these investments provide a rate of return in excess of the interest rate on the government debt (and do not crowd out more profitable private investment expenditure), then the future benefits of the current deficit-financed government spending exceed the future tax costs, and the future population derives a net benefit from the current government spending. If the government investment has a rate of return less than the interest rate, the future population will be worse off than they otherwise would be.

  Published: January 16, 2006 12:27 PM

• billwald

  One upside of govt debt is that I havn't had to learn to speak German, Japanese, or Russian.

  Published: January 16, 2006 1:10 PM

• Paul Edwards

  “Yet I have always been troubled by the emphasis on the nationality of bondholders, because it implies that federal deficits are benign so long as "we owe it to ourselves." As we have seen, this is simply not the case.�

  Bang on again!

  As an aside, the spending of tax money itself is partially subject to the same arguments this article makes in reference to deficit spending. Taxation takes money from the pockets of the taxed, and consumes it. If the money were not taxed and consumed by government, some of that money would also have been saved and invested rather than consumed. So, while government borrowing draws purely savings from the private sector, taxation to a degree does the same, because some tax dollars would also have been saved. Therefore, government spending in general and not only deficit spending contributes to the fact “that the structure of physical capital goods that the next generation inherits will be less developed than� it should.

  Good article.

  Published: January 16, 2006 1:19 PM

• Paul Edwards

  Mark,

  "All paper money started out as an IOU (in the private sector), then banks were nationalised and legal tender was established and finally the government stopped keeping reserves (i.e. it spent them)."

  Actually paper money started out as warehouse receipts for gold, as substitutes for real money. Due to the fraud of FR banking, they gained a characteristic of an IOU and were discounted based on the assessment of the likelihood of actually successfully redeeming the notes for gold.

  "The fact that the $20 bill has no value unlesss the government stands is surely reason enough to support the government."

  With your exact same premise I'd argue the opposite conclusion: why support a government that cheapens your money, lies and cheats, distorts the market and steals from one group to enrich a smaller favoured group?

  Published: January 16, 2006 1:30 PM

• Bill Dowis

  Thank you Mr. Edwards: You have cited the reason I have divested myself from all fiat currencies!
  The average Amereican is dedvoid of the mental tools to mearly contemplate what is occurnig to them and within their country.

  It would seem to me the US citizenry would conclude anything other than the US developing technologies and manufacturing sites that serve as instruments to attract the cherished currencies and assets of other countries is a massive train wreck in the making.

  I also wonder when the the Chinese and other holders of US debt will become bored with the accumulation of dollars and demand something else for the payment of outstanding obligations.

  Published: January 16, 2006 7:17 PM

• Mike Sproul

  Paul:

  Correction on how paper money started out:

  In 1690, the Massachussetts Bay colony couldn't pay its soldiers, who were on the verge of a riot. The colony decided to print paper shillings (a govt. IOU) and pay the soldiers with them. The governor declared that paper shillings were acceptable for taxes on a par with silver shillings. The paper shillings circulated, and stimulated business. They worked so well that by 1710 every colony had issued its own paper money, despite official disapproval from Britain. This example is sometimes cited as the first governmentally issued paper money in the Western world, though China had done it earlier, and of course private IOU's had previously circulated as paper money.
  

  Published: January 16, 2006 7:24 PM

• A.B. Dada

  Government debt has a big upside, which is the reason for government debt in the first place: cronyism.

  Debt takes care of the cronies. That is all that matters in the end.

  50 people earning US$20 million a year a piece from favoritism will fight 100 hours a week for it. 300 million Americans losing $3 each a year to pay those 50 won't blink at what they lose.

  Published: January 16, 2006 8:00 PM

• Paul Edwards

  Thanks Mike,

  I recall you presenting that bit of history, which seems plausible. But as i recall your rendition of the event, the silver was delayed on a ship and if so, i would argue that "on a par with silver shillings" literally meant to the holder of the paper that they were receipts for the silver actually held in vaults on the ship and were redeemable on par at the point the silver was landed. Did the ship ever land and were the soldiers ever allowed to redeem their notes for silver? Or did the government immediately default rendering those notes at a considerable discount to silver (constituting, what else, theft by government via paper money)?

  In any event, paper as a money substitute originally had to be (or appear to be) backed by and redeemable in gold or silver or else people would panic; given a worthless piece of paper in exchange for real money would constitute a real bad day back then.

  Published: January 16, 2006 8:22 PM

• Paul Edwards

  Bill Dowis,

  I hear you mate. Just remember that we still buy our groceries with paper, and another depression is always a possibility.

  Published: January 16, 2006 8:43 PM

• P.M.Lawrence

  That remark about paper money starting in Massachusetts is regrettable US-centrism. Wikipedia has a description of it being used in Sweden in the 17th century, and I have seen a report of it being used in siege conditions in Spain in the 15th century (Washington Irving's "Conquest of Granada"). If "paper" need not be taken litearlly, England was using the tally stick method of producing tax-backed tokens even earlier, and probably did not originate the approach.

  I don't think that idea that government debt is always that distortionary is an absolute truth. Certainly, governments are far worse at picking winners, but there were many cases - in the 19th century in particular - when they only had to copy successes elsewhere, and could use municipally or centrally issued bonds for things like railways, bridges, canals etc.

  Of course, they also had a tendency to misclassify things that they wanted as this sort of capital, and they often didn't appreciate that what worked in one place at one time might not always transfer well or might become obsolete (think US canals - even the Erie canal merely diverted St. Lawrence traffic without increasing total capacity very much), but nevertheless government debt wasn't always 100% guaranteed to be wasted.

  Of course, it's still a pretty good bet, particularly these days.
  

  Published: January 17, 2006 6:23 AM

• Yancey Ward

  Governement debts serves the purpose of allowing the government to consume more than it would otherwise be able if it had to rely solely on taxation. A tax in the present is more painful than a tax in the future, especially if one can pass that tax to someone else. I consider government debt a great moral wrong against our children, but I am under no illusion that if we spent just as much, but did it with taxation rather than debt, that we would actually be doing them a favor. Government spending is the true enemy, debt is just its ally.

  Published: January 17, 2006 9:33 AM

• Skye

  In regards to FR banking, where exactly does the fraud or illegality come in?

  
  For example, on a free market you could have a store owner lose revenue due to the competition from across the street. But no one's rights have been violated. Though both own there store's and the contents therein, neither one owns the value thereof.

  
  So, in regards to FR banking - each man owns his own money and property, but not the value of that money and property - correct? Whose rights have been violated, if it originates out of voluntary, cooperating individuals?

  In other words. Ultimately, anything can be traded for something else, thereby providing the same service as money. However, the value of anything fluctuates on the market. Therefore, let's say you often use eggs to trade with your neighbor, and then your other neighbor erects a huge chicken barn and undercuts you though mass production. Your eggs are not as valuble anymore, but you didn't own the value in the first place. And no one's rights have been violated.

  I notice there are differences with that analogy and FR banking, but again where exactly does the fraud come in?

  What am I missing?

  Published: January 17, 2006 11:03 AM

• Paul Edwards

  Hi Skye,

  The problem is, people can voluntarily make fraudulent agreements. That an agreement is voluntary isn’t a sufficient criterion against fraud.
  
  Why is FR banking fraudulent? From Hoppe, http://mises.org/journals/rae/pdf/rae7_2_3.pdf:

  “…First off, it should be noted that anything less than 100 percent reserve deposit banking involves what one might call a legal impossibility. For in employing its excess reserves for the granting of credit, the bank actually transfers temporary ownership of them to some borrower, while the depositors, entitled as they are to instant redemption, retain their ownership over the same funds. But it is impossible that for some time[,] depositor and borrower are entitled to exclusive control over the same resources. Two individuals cannot be the exclusive owner of one and the same thing at the same time. Accordingly, any bank pretending otherwise-in assuming demand liabilities in excess of actual reserves-must be considered as acting fraudulently.

  “Second, in lending its excess reserves to borrowers, the bank increases the money supply,... there will be more money in existence now than before, leading to a reduction in the purchasing power of money (inflation) and, in its course, to a systematic redistribution of real income in favor of the bank and its borrower clients and at the expense of the non-bank public and all other bank clients. The bank receives additional interest income while it makes no additional contribution whatsoever to the real wealth of the non-bank public (as would be the case if the interest return were the result of reduced bank spending, i.e., savings); and the borrowers acquire real, non-monetary assets with their funds, thereby reducing the real wealth of the rest of the public by the same amount.�

  Published: January 17, 2006 11:40 AM

• Logan

  Paul,

  FR banking is not fraudulent. The arguments against FR banking usually turn on definitions, such as what a deposit really means, or are utilitarian, such as the second example of Hoppe's, which criticizes FR banking on its economic effects rather than its legitimacy in law.

  As for Hoppe's first point, he makes the one fundamental error that all anti-FR bankers make, which is the error of "instant redemption." To recap Hoppe's point:

  "For in employing its excess reserves for the granting of credit, the bank actually transfers temporary ownership of them to some borrower, while the depositors, entitled as they are to instant redemption, retain their ownership over the same funds."

  But depositors don't have instant redemption rights as a matter of universal fact. When the depositor goes to the bank, he agrees to put his money in the bank and have it safe and possibly get an interest return on it. But the bank can stipulate the conditions governing how and when the depositor's account can be accessed. For example, the bank can say that its hours are 9-5, Monday through Friday, and they have no ATMs. Would this bank be violating the person's right to instant redemption by not allowing them to make withdrawls outside business hours? Of course not, because the depositor agreed to the terms set by the bank for deposits.

  As for the more complicated point about loans and "instant redemption" by the depositor, it follows the same principle. The depositor puts his money in the FR bank after signing a contract saying that all of his money might not be there if everyone comes to the bank at once. The FR bank, to be sure, will try its hardest to be fiscally prudent so that every withdrawal request is met instantly. But a depositor is not dumb. He might request that the bank put into the contract that if the bank refuses withdrawals he will get an extra interest payment on the balance of his account for the duration of the restriction. Also, the depositor might request that he is entitled to the assets of the bank in the case of bankruptcy equal to the balance of his account at the time of bankruptcy.

  The main point here is that the money being deposited in the bank is not subject to instant redemption by the depositor, and therefore does not create a "legal impossibility." It is subject to a contract between the FR bank and the depositor, both of which have certain rights of control to the money. Since the depositor gives up some of his exclusive control of the money to the bank, the bank is allowed to control the money as it sees fit, as long as it meets all contractual obligations. If the depositor wanted exclusive control over his money, he'd either choose a 100% reserve bank or his mattress, not an FR bank.

  And a final point. Fraud is defined as "deception carried out for the purpose of achieving personal gain while causing injury to another party." FR banking is not a deceitful activity because it does not hide its true nature from the public. Everyone knows what's in the contract and are free to not choose FR banking. Businesses can choose not to take an FR bank's privately issued note if he believes it to not be worth the paper it's printed on. Furthermore, if any anti-FR bankers have put money into an FR bank, then they would also have to admit that they were knowingly involved in a fraudulent scheme, as they have described it. The only way they could stay "clean" would be to use only cash that was stored in their house, a safety deposit box, or only used time deposits at the bank to supply loanable funds.

  Published: January 17, 2006 1:56 PM

• Yancey Ward

  Logan,

  A bank that takes a deposit, that by contract can be taken back out tomorrow, is committing fraud if it loans its funds in such a way that the money is not available tomorrow, then it has committed fraud. I agree with you that a depositor can contract with the bank for any length of time between the deposit and when the deposit can first be withdrawn, be that 1 day, a week, or 10 years. To not commit fraud, the bank would have to structure its loan portfolio in such a way that its funds on hand equal the amount that can be withdrawn by contract at any given moment in time. This is not fractional reserve banking. Fractional reserve banking is the creation of credit above the amount of the total deposits of the bank, irregardless of the duration of the deposits.

  Published: January 17, 2006 2:08 PM

• Vince Daliessio

  Logan,

  While your point about the PRACTICAL limitations of depositors' access to funds is well-taken, and the legality of contracts, such as Certificates Of Deposit cannot be disputed, as an also practical matter fractional reserve banking can only be prevented from being a system in default by extraordinary government privilege as embodied in the Fed. Take away the fed, and bank welfare legislation, and there would be much less of it.

  Published: January 17, 2006 2:10 PM

• Paul Edwards

  Logan,

  Your comment “But depositors don't have instant redemption rights as a matter of universal fact.� and those that follow it in that paragraph ignore a very simple and indisputable fact. People use a checking account, and use the checks against them as money. They are writing checks against money that they claim to hold. When someone writes and accepts a check, they are making a money transaction, not a credit transaction. The person who sells you groceries that you pay for with a check is taking your claim to money you hold in your checking account, not an IOU.

  And while you are writing that check against money you allegedly hold in your checking account, someone else is also writing a check against the same money you hold in your account (presuming it was your deposit and the other person’s loan). For accounting purposes the same money is counted twice in two checking accounts. You and he are both transferring claims against the same money. This is clearly fraudulent.
  

  Published: January 17, 2006 2:57 PM

• billwald

  "I also wonder when the the Chinese and other holders of US debt will become bored with the accumulation of dollars and demand something else for the payment of outstanding obligations."

  Then they will have 3 options:
  1. Sell dollars to anyone who wants them
  2. Spend them in the USofA on goods and services
  3. Purchase land or businesses in the USofA.

  Published: January 17, 2006 3:27 PM

• RPM

  Bill Wald wrote: One upside of govt debt is that I havn't had to learn to speak German, Japanese, or Russian.

  
  Thanks, Mr. Wald! In response to this article, a few people accused me of attacking a straw man; they claimed that nobody had ever been silly enough to suggest that the Nazis could've taken over the continental US.

  But more seriously, why was government debt needed to do this? Those tanks, bombers, etc. were produced out of present resources. Unless you bring in foreign creditors to the argument, deficit financing certainly doesn't ease the opportunity cost of wartime expenditures for the community as a whole.

  Published: January 17, 2006 3:29 PM

• Logan

  Yancey & Paul,

  I guess I might be a bit confused about the nature of FR banking. The way I think of FR banking is that it is basically a system of loaning out funds without having to sign a time deposit contract every single time. To you two, it seems that the whole history of FR banking is one big accounting fraud, even during eras where bank socialism was not propping up insolvent banks. To quote George Selgin:

  "Thus, during the entire Scottish free-banking era, which lasted for more than a century ending in 1845, Scottish bank liability holders lost a grand total of £32,000, notwithstanding that for much of this period the typical Scottish bank held gold reserves equal to less than 3 percent of its outstanding notes."

  It seems to me that just about everyone got their money during that time and the few who lost it due to bank failures are just victims of bad business decisions, like investors and creditors of failed dot-coms. To me, fraud is all about people not getting what they were promised. For example, Paul, I'm not sure if all those checks being written are being accounted for properly (it's kind of complicated the way it's described). But here's a simple way to test if it is fraud: did the shopkeeper get his money? If he did, then all is good. If not, then the check writer wrote a fraudulent check. As long as everyone gets paid according to the sales or loan contract, what exactly is your beef? I think that anti-FR bankers use a lot of tricky verbiage to conceal the fact that if people get paid what they are promised and people get the good or service they were promised every time, then fraud is not committed.

  Vince,

  I agree that bank socialism is propping up FR banks that would otherwise fail, but I've read enough literature to see that far more people prefer FR banks to 100% banks throughout history. They would still be here and there would probably be plenty of them after the Fed and deposit insurance were abolished.

  Published: January 17, 2006 4:28 PM

• Sione

  Logan

  Plenty of people prefer to get stuff for free rather then work for it. Does that notion support the act of theft?

  If FR banking is OK then so is counterfeiting. Interestingly enough the govt. considers counterfeiting to be a terrible crime (so do the banks funnily enough). Perhaps they do not like the competition.

  If FR banking is OK, then so long as you get your "money" you should be well satisfied with privately printed copies of dollar bills. But I'm betting you'd be one of the first to dishonour privately photocopied dollar notes...

  Care to explain the difference between counterfeiting by the FR banking system and counterfeiting by private individuals?

  Sione

  Published: January 17, 2006 5:29 PM

• Paul Edwards

  Hi Logan,

  Sione is more to the point than I am, but I’ll take one more kick at the cat in my own round about manner.

  The indirect exchange economy uses money and money substitutes. That used to be (and would be today in a free market) gold and gold certificates (warehouse receipts) respectively. Today the corresponding items are fed notes and bank checks. When you use a money substitute such as a check, you transfer title, or ownership to money in exchange for goods. Title to real money is being transferred (in this fiat system, I must use the term “real� loosely). However, FR lending creates a second title to the same money when a bank creates a new checking account as it lends new money based on previous deposits. This fundamentally and necessarily results in two different people proposing to posses exclusive title to the same money. It’s just not legally possible.

  When you buy a house you must check for clear title to the house. If you find that two people possess a title to the same house or there is a dispute over title, you have a very big problem in buying this house. The principle applies to money in the very same way. There’s good reason you can’t sell a house if someone else also claims exclusive ownership to it, maybe it’s not yours to sell. And you can’t ethically transfer ownership to money that someone else also claims exclusive ownership over because of just this same reason.

  Published: January 17, 2006 6:33 PM

• Logan

  Sione,

  The difference between a counterfeiter and a FR bank is that the bank acknowledges its debts while the counterfeiter does not. A counterfeiter presents a money certificate to a store claiming that it is good for the redemption of one gold ounce, when in actuality he has no intention of transferring over that one gold ounce when the store attempts to redeem the certificate. The bank, on the other hand, has the means and the intention to redeem all money certificates printed with its name for that gold ounce.

  To recap, the counterfeiter does get something for nothing. He gets groceries while the store gets no gold. With the FR bank, the store owner gets his gold and is therefore not harmed. Without harm, there can be no criminal act.

  Unfortunately, most anti-FR bankers cannot get their heads around the concept of managing cash flow. Just like most businesses and people, FR banks cannot possibly meet every debt obligation if they all are "called in" at once. Businesses have account receivables and accounts payables departments to manage the flow of cash in and out of the business so that they can meet their current obligations. No one calls them fraudulent because they take out loans and have outstanding invoices that they could not pay if every single one were added up and then called in. As long as they pay off their debts and invoices as they come due, then no one complains. It's the same with FR banks. As long as they redeem withdrawal requests according to the depositor's contract and redeem money certificates to vendors when they request specie redemption, then I don't see harm to either depositor or money certificate receiving vendors. And if they do not harm those who've they contracted with, then fraud is not committed.

  Published: January 17, 2006 11:15 PM

• Logan

  Paul,

  "This fundamentally and necessarily results in two different people proposing to posses exclusive title to the same money."

  The depositor does not have exclusive title over money he deposits at an FR bank. His contract with an FR bank necessarily means that the bank gets to control when and where he can access his money and how much he can withdraw. The whole point of the FR bank is to control the flow of cash to and from depositors, lenders, and outside vendors trying to cash its money certificates. Thus, it's not the depositor who has exclusive control of the money or the lender with the new checking account who has exclusive control. It's the bank who has exclusive control of the money, working within a contractual framework that connects the cash flow of all who do business with the bank.

  Published: January 17, 2006 11:33 PM

• R.P. McCosker

  One notion Murphy doesn't address -- perhaps because it can be used to defend many kinds of government spending irrespective of the debt aspect -- is that government borrows as an "investment."

  Government is analogized with the borrowing for capital to start a business, or a family to buy a home. Likewise, government borrows purportedly to "invest" in making a better world for tomorrow: It "invests" in education, hospitals, space exploration, flood control, technology, "urban renewal," "youth," transportation, whatever. It even "invests" in recruiting bright young college graduates into "public service."

  Conversely, failure to "invest" in such "public goods" is deemed pennywise but pound foolish.

  This ties in nicely with government debt, because borrowing is then justified for procuring what we need to have a better future.

  Question: Are these things really good "investments," and ought the coercive agency of government be undertaking them?

  Published: January 18, 2006 1:36 AM

• Peter

  A counterfeiter presents a money certificate to a store claiming that it is good for the redemption of one gold ounce, when in actuality he has no intention of transferring over that one gold ounce when the store attempts to redeem the certificate. The bank, on the other hand, has the means and the intention to redeem all money certificates printed with its name for that gold ounce.

  The bank issues two, three, perhaps even ten or twenty, certificates claiming to represent a single gold ounce. There's no way it can ever redeem most of them, since there's only one ounce of actual gold - how can it "redeem all money certificates [...] for that gold ounce" if there's only one ounce and multiple certificates?

  Published: January 18, 2006 3:43 AM

• Logan

  Peter,

  "The bank issues two, three, perhaps even ten or twenty, certificates claiming to represent a single gold ounce. There's no way it can ever redeem most of them, since there's only one ounce of actual gold - how can it "redeem all money certificates [...] for that gold ounce" if there's only one ounce and multiple certificates?"

  If you read further down in that same post, you might see the answer. The certificates state that it is good for the redemption of one gold ounce. It would not state that all certificates are backed by one ounce of gold at the present time. The only legal responsibility the bank has to holders of its private issue notes is to honor the contract when it comes due. Remember how later in the post I described that just about everyone has debt obligations that, if added up, could not be paid off if immediately called in? Well, the FR bank could not redeem those 5, 10, 20 certificates all at once just as most people cannot pay off their credit card, student loans, and mortgage all at once. We are only liable for our current debt obligations, and we make payments on our debts when the bills come every month. The FR bank does the same thing. Every time a money certificate is deposited in another bank, the FR bank must honor its debt obligation and transfer the correct amount of gold; no more, no less. The earlier Selgin quote demonstrated that during the century of Scottish free banking, they were able to pay virtually all of their bills "despite" only carrying 3% specie reserves relative to their outstanding notes. And as long as the bills are paid when they come due according to a contract, then you or the FR bank are not in breach of contract or committing fraud.

  Published: January 18, 2006 7:49 AM

• Peter

  In this case, the bills are due right now. It's not unheard of for people to "borrow" money from their companies, intending to pay it back before anyone notices. And often, they get away with it, just like your Scottish banks. But when caught, they go to jail, because it is fraud, even if they have every intention - and the ability - to pay it back.

  Oh, and because I just know you're going to say something like "but the banks don't make a secret of it" (which is not entirely true), if such a person went around shouting from the rooftops about what they were up to, that would only land them in jail that much faster!

  Published: January 18, 2006 8:36 AM

• Yancey Ward

  I will take one more try at this:

  Logan,

  First, we need to define what fractional reserve lending actually is. Fractional reserve lending is the lending of funds that are in excess of the total deposits of the bank. For example, Bank A has total deposits (savings) of $1 million dollars and has a loan portfolio of $950,000- then Bank A is not engaged in fractional reserve lending. Now if Bank A is well managed, then, at the time we are having this discussion, the depositors as a whole will not be able to withdraw more than $50,000-Bank A has the necessary reserves, though it is a fraction of the total deposits. If Bank A is not well-managed, and the contracts for deposits are such that, today, depositors show up demanding $100,000 and the banks loan contracts do not allow the immediate calling of an additional $50,000, then the bank is in technical default, and if Bank A cannot convince some of the depositors to accept a portion of its loan portfolio rather than cash, then it is in actual default (I am ignoring insurance and risk mediation for the sake of simplicity) and it has committed a fraud. However, Bank A still has not engaged in fractional reserve lending since it has not loaned out an excess of its deposits and created multiple claims against saved resources (remember, real savings are not cash; cash is just the claim on real savings).

  We will use Bank B as an example of fractional reserve lending. Bank B has total deposits of $1 million and a loan portfolio of $10 million- Bank B is a fractional reserve bank. Let us suppose it keeps $250,000 in cash reserves, and let us suppose it manages its deposit contracts well, and that at any point in time its depositors can never withdraw more than $250,000, then Bank B can never technically default on it's depositors accounts. However, it is still a fractional reserve bank, and I assert it is committing fraud. Why? Bank B's depositors have decided not to consume a portion of their production, and they have deposited these savings, denominated in dollars, in Bank B. Depending on the contracted duration of the deposits, it is completely proper for Bank B to loan these saved funds, which are claims against unconsumed production (real savings), to any who wish to consume for any reason more than they are producing today. However, if Bank B loans out more cash than it's depositors have actually saved in real production, then it has created multiple cash claims against the same, limited pool of saved resources. In other words, it has created inflation, and it has defrauded all savers and consumers by devaluing their cash holdings.

  Published: January 18, 2006 8:58 AM

• Paul D

  "One upside of govt debt is that I havn't had to learn to speak German, Japanese, or Russian."

  It seems to be a habit of Mr. Wald to throw out a trollish comment like that without making any pretence of defending it.

  Let's see how many incorrect premises are implied in that one statement:

  1. There has ever been an overwhelming, immediate danger of Germans, Japanese, or Russians actually conquering the US. (false)

  2. Private citizens and corporations are incapable of defending their property, and need someone to steal their resources, through deficit spending and taxes, for this purpose. (false)

  3. Socialized, unaccountable security is more efficient than privately purchased security. (false)

  4. Assuming a hypothetical threat exists, being forced to give up your income and even your body at gunpoint is better than being forced to learn Japanese. (Arguably false; heck, I'm learning Japanese without coercion.)

  It seems to me that when there's a war on, the side that's taking your money, stealing from your children, and sending your friends to be killed is the enemy, not the good guys.

  Published: January 18, 2006 9:06 AM

• Dennis Sperduto

  The fundamental economic/financial problem involving fractional reserve banking is not "managing cash flow". Fractional reserve banks are inherently insolvent because the time structure of their assets does not match the time structure of their liabilities. This is a balance sheet, and not a cash flow, problem. In general, the time structure of a FR bank's deposits (liabilities) is much shorter than the time structure of its loans (assets); a classic, risk-laden case of borrowing short, while lending long. The extreme example of this situation involves the lending of demand deposits, which by definition are required (absent government intervention) to be redeemed at any time upon the demand of the depositor, while the loans made with these deposits generally are not callable instantaneously by the FR bank.

  Published: January 18, 2006 9:42 AM

• Logan

  Peter,

  The bills are not due right now in this case. If I receive 20 ducats from someone who does business with an FR bank, I can hold on to those ducats for as long as I want. Let's say that I even lose one in a couch cushion. That one ducat is not a debt obligation that the bank must pay back to me because I have not presented it to my bank (who would demand specie redemption from the issuing bank) or to the FR bank itself. If I find it 1 year later during spring cleaning and present it to the bank, only then are they obligated to redeem it.

  "It's not unheard of for people to "borrow" money from their companies, intending to pay it back before anyone notices. And often, they get away with it, just like your Scottish banks."

  By "borrow," I'm guessing that you mean stealing. FR banks do not steal money from anybody. They create debt contracts with depositors, lenders, and the vendors that receive their money certificates. They honor their debt contract when the payments come due. They are not getting away with "it," because there is nothing to get away with. Anti-FR bankers like you are obviously confused between the difference between debt and bailments. Bailments mean that the bank must have the depositor's money or assets, often the exact same money or assets, at the bank at all times. If I put one gold coin in a safety deposit box, that one gold coin better be there when I come back.

  But a debt contract is not a bailment. The FR bank signs a debt contract with the depositor for the control of his funds. The FR bank must pay back the depositor according to the terms of the debt contract. As stated in another post, depositors cannot dictate the terms in which they can withdraw their money from the bank exclusively. They must abide by the debt contract they signed and can recover their debt to the bank only on the terms set out in the contract. Thus, as with all debts, the bank is allowed to use the funds loaned to them in any way that they please, provided they pay back the debt to the lender in accordance with the contract. This is also the reason why the “two exclusive owners� theory of FR bank fraud is incorrect. The depositor transfers ownership of his loanable funds to the FR bank in return for interest payments and/or services and can recover the principal of the loan according to the debt. In the meantime, the FR bank has exclusive control over those funds and can make other loans with that money, just like a business or person can loan out funds it borrowed from a bank. This is the business of the FR bank: getting loans from those with loanable funds, paying interest on them, and finding borrowers to loan out these funds to at a higher interest rate.

  And they should stand on the rooftops and shout it out, Peter, because they are doing nothing wrong.

  Published: January 18, 2006 9:44 AM

• Logan

  Dennis,

  Your analysis of the economic/financial risks of FR banks is well taken, but that is not the point of the anti-FR bankers. They are claiming fraud for any bank that holds fractional reserves. Just like stealing a candy bar is still theft regardless of its relative insignificance, they would still claim that a bank is still acting fraudulently whether it maintained 1% reserves or 99.9% reserves. A 99.9% reserve bank would not have the problems that you detailed in your analysis of FR banking, but somehow, it would be Enron-esque in its operations to Peter, Paul, and Yancey. Whether an FR bank can maintain this "inbalance" of their balance sheet is a business form problem, not a criminal conspiracy.

  Published: January 18, 2006 9:58 AM

• Vince Daliessio

  Logan,

  I disagree with your assertion that the market somehow "wants" FR banking. In a free-market scenario, some could and would no doubt be tempted (by the payment of higher interests on savings) by FR banks. But unregulated FR banking in the lead-up to the Depression was responsible for many of the bank failures and subsequent runs of the era. The general public would prefer to keep SAVINGS (not checking accounts) in 100% banks or other secure investments, even at extremely low or zero yields. The fact that they don't is further evidence that right now they have no such option. Savings accounts, after taking into account monetary inflation and interest taxation curently yield net negative returns. Thus are Americans not only failing to save, but actively borrowing others' money and spending that too, since interest received is taxed, while interest paid is not (and in the case of mortgages and home equity loans is subsidized).

  Published: January 18, 2006 10:03 AM

• Logan

  Vince,

  I'm sorry, did I just hear "unregulated FR banking in the lead-up to the Depression was responsible for many of the bank failures..."? There was a key regulation that might explain bank failures, and that was the restriction placed on branch banking. Canada, which allowed full branch banking, had no bank failures during the depression because larger, more fully diversified national banks were allowed to compete with local banks. When the financial storm hit, Canadian banks were stronger than the weak local banks of America and rode out the Depression.

  Published: January 18, 2006 10:20 AM

• Vince Daliessio

  Logan,

  Of course you are right - the restrictions on branch banking (lobbied for by the local banks, remember?) exacerbated the situation.

  That doesn't mean in the absence of the restrictions there would have been unbridled practice and full public acceptance of FR banking - in fact, in the free market, FR runs up against natural limitations of risk tolerance and available capital without the moral hazard of the Fed to obviate these limitations, which was my point anyway, (and not that I had forgotten that I read "FDR's Folly").

  Published: January 18, 2006 11:12 AM

• Michael A. Clem

  Interesting point about branch banking, Logan. However, I thought that one of the problems with banks before the Depression was that they had been required by government to lower their reserves, thus making them more vulnerable when the economic downturn occurred.

  Published: January 18, 2006 11:18 AM

• billwald

  Why is govt debt so much worse than private debt?
  For example, a community association borrows money to repair its roads. A municipality borrows money to repair its roads. Forget the theoretical freedom issues. What is the economic difference?

  Published: January 18, 2006 11:18 AM

• Larry N. Martin

  Are you serious? The difference is the use of "other people's money", especially without their consent.

  Published: January 18, 2006 11:22 AM

• Yancey Ward

  billwald,

  On the national level it doesn't make much sense to borrow money for present consumption when the government could just tax what is needed. As the author of the blog entry pointed out, the federal government doesn't borrow steel or concrete from the future- all that is consumed by the government must exist in the present. Government debt just makes the spending seem less painful to those who pay taxes, mostly because they hope to die before having to pay the tax.

  Published: January 18, 2006 12:04 PM

• Vince Daliessio

  Taxes = claims on current income
  Debt = claims on current + future income
  

  Published: January 18, 2006 12:27 PM

• Vince Daliessio

  Monetary Inflation = claims on past, current, and future income

  Published: January 18, 2006 12:28 PM

• Paul Edwards

  "By "borrow," I'm guessing that you mean stealing." More specifically, I think he means embezzling.

  Logan,

  It strikes me you are conflating demand deposits (bailment), i.e. checking accounts, with time deposits (loans) such as certificates of deposit. If you are arguing it is ethical to loan out funds (even 100%) obtained through issuing CD's i am wholeheartedly in your court. CD's won't be used as money.

  It is in the case of demand deposits where the bank promotes and the customer maintains the illusion of a bailment relation to his deposited money that the fraud exists. One does not accept checks on the understanding that he is receiving an IOU. He expects that the money is immediately available. Checking account balances are not loans; they are bailment.

  Published: January 18, 2006 1:54 PM

• Logan

  Vince,

  You're right on the Fed. FR banks, on the true free market, are legal forms of business, which was the point I was trying to make. But they are dangerous forms of business when they are all tied to a central bank and their potential losses are socialized through deposit insurance. It's the old saying "Privatize the gain, socialize the loss." FR bankers, not scared by the thought of having their depositors organize a bank run, can pump up interest rates on their loans and drop their reserve ratios without fearing cash shortages. FDR's folly was a good book, BTW.

  Michael,

  Well, that's not exactly an argument against free market FR banks, now is it? The Fed wanted banks to keep pumping out cheap credit during the 1920s, for whatever reason (helping England, etc.) and so it would be natural for them to require lower reserve ratios. I doubt the FR banks would lower reserve ratios on the free market unless there were good financial reasons, rather than by government fiat.

  Published: January 18, 2006 1:55 PM

• Michael A. Clem

  I haven't commented one way or the other on fractional reserve banking--I'm 'reserving' my comments. ;-)
  
  I just wanted to verify what I thought I knew. I agree that a free market would discourage low ratios.

  Published: January 18, 2006 2:01 PM

• Yancey Ward

  It seems to me that most of you are arguing past one another. There seems to be a misunderstanding about what fractional reserve lending is and is not. A fractional reserve lending bank lends out in excess of its total deposits, and it does not matter what the nature of those deposits is, whether they are 5 year CDs, 10 year CDs, or checking accounts.

  Logan is correct when he writes that a bank can manage its affairs in such a way that the withdraws each day are less than or equal to the actual cash reserves held back. Just because a bank keeps a fraction of reserves in comparison to its total deposits does not constitute fractional reserve lending. As long as the outstanding loans do not exceed the deposits of all types, then the bank is not a fractional reserve lender. Fractional reserve lenders create, out of thin air, multiple claims to the same pool of real savings.

  Published: January 18, 2006 2:20 PM

• Logan

  Paul,

  Money certificates and checks are IOUs. If I go to a Best Buy to buy a TV for one gold ounce ($544 as of today), then there are two ways I can pay. I could have the one gold ounce in my pocket, and give it to the cashier and be on my way with my TV. Or, I could give the cashier a money certificate or check payable to Best Buy. The cashier accepts this form of payment in lieu of an ounce of gold because the store expects to redeem this piece of paper for real gold. The money certificate or check basically says "The bank that issued this money certificate or check OWES YOU one gold ounce." An IOU is created any time that you don't pay the full price with "real" money (in this case, gold) at the time of purchase. Best Buy will then take this IOU and either redeem it at the issuing bank or deposit it in their bank, which will then arrange the transfer of the one gold ounce from the issuing bank's reserves, and my bank will debit my checking account.

  The time frame involved is not important to the technical nature of the transaction described above. Whether people are under the illusion that their account is a demand deposit rather than a loan agreement with the bank is irrelevant to its legality. Likewise, if the vendor is under the illusion that a check or money certificate is not an IOU is also irrelevant to its legality. Only when the bank flat out says that their fractional reserve deposits are available on demand in full will they be guilty of fraud. When the depositor signs a contract or a vendor accepts checks or money certificates, they are accepting the terms of a loan contract and SHOULD view it as such. Their illusions are brought on by the government insuring that no bank will be bankrupted due to failure to honor its debt contracts. If a bank goes bankrupt, then both depositor and vendor would have standing as creditors who could assume ownership of bank assets (outstanding loans, land, buildings, etc.).

  Published: January 18, 2006 2:22 PM

• Paul Edwards

  Hi Logan,

  I disagree with you on what constitutes an IOU vs. a money substitute. What i would call a money substitute, a certificate of money ownership, a title to money ownership, a warehouse receipt for money, or a check, you would call an IOU. I claim there is such a thing as a money substitute and that it is not an instrument of debt, but rather a title to ownership of money.

  You put it this way: "The bank that issued this money certificate or check OWES YOU one gold ounce."

  I would put it this way: "The bank that issued this money certificate or check HOLDS YOUR one gold ounce at par, available on demand."

  OWES vs HOLDS. It's a significant difference, and the premise of money substitutes suggests the latter interpretation.

  It just occurred to me you may not accept the concept of money substitutes.

  Published: January 18, 2006 3:20 PM

• Paul Edwards

  Yancey,

  I differ with you on your interpretation of FR banking. It is of crucial importance whether we are discussing funds derived via checking deposits or CDs. The question of FR lending does not even arise if all the bank is doing is lending out funds borrowed via CDs. In that situation at worst, we can blame the bank for incompetence in managing current assets against current liabilities, which is not necessarily fraudulent.

  A short recap of bank's balance sheet in steps of FR banking on a checking account:

  Day 1) We're good: depositor deposited $100 in checking account.

  ..A.........|..L
  --------------------------------
  $100 cash.. | $100 checking deposit

  Day 2) Already fraudulent loan is created here.

  ..A.........|..L
  ---------------------------------
  $100 cash...|.$100 checking deposit
  .$90 Loan...|..$90 checking deposit (thin air)

  Day 3) Fraud is almost revealed here as original depositor withdraws $90 on demand:

  ..A.........|..L
  ---------------------------------
  .$10 cash...|.$10 checking deposit
  .$90 Loan...|.$90 checking deposit (thin air)

  Day 4) Fraud revealed here as borrower withdraws $20 of loan on demand and reveals bank's insolvency via the negative cash asset:

  ..A.........|..L
  ---------------------------------
  .$-10 cash..|.$10 checking deposit
  .$90 Loan...|.$70 checking deposit (thin air)

  Busted for creating and issuing dual claims on the same dollars which both customers acted on.

  Published: January 18, 2006 3:51 PM

• Logan

  Paul,

  Yancey is probably right in that maybe we are talking past each other and have our definitions conflated. I guess I don't agree with the concept of money substitutes, for the most part. You either pay with gold or you pay with paper that says that the issuer owes you gold in the future. So to me, a debt is created whenever a bank issues private notes or checks. The bank will pay off the debt when it comes due by either a "citizen" holder of these pieces of paper or their bank representative. The citizen could redeem it at the issuing bank or their bank. If they redeem it at their bank, the bank will assume ownership of the debt claim and request a transfer of gold from my bank to their bank through a private clearinghouse.

  I would say that "the bank that issued this money certificate or check HOLDS YOUR one gold ounce at par, available on demand" applys only in the case of a real demand deposit such as a safety deposit box or an account explicitly off limits to loaning unless authorized by the depositor through a time deposit such as a CD. So, any paper documents from this account are money substitutes while money not subject to bailment are debt claims. Do we understand each other now?

  Published: January 18, 2006 4:23 PM

• Sione

  Logan

  You wrote: "The difference between a counterfeiter and a FR bank is that the bank acknowledges its debts while the counterfeiter does not."

  The counterfeiter, like the bank, pays his debts with notes. He, like the bank, issues notes to his creditors and colleagues. As with the bank, the counterfeiter makes sure everyone gets their "money." He, like the bank, recognises debts and pays for them exclusively with notes or paper, carefully avoiding paying for them with assets or labour. He pays with a promise. So does the FR bank.

  Quoting: "A counterfeiter presents a money certificate to a store claiming that it is good for the redemption of one gold ounce, when in actuality he has no intention of transferring over that one gold ounce when the store attempts to redeem the certificate. The bank, on the other hand, has the means and the intention to redeem all money certificates printed with its name for that gold ounce."

  Not so. The bank has no such intention. Besides which, the bank is physically incapable of doing as you wish. Remember it is a FR bank. This type of organisation lacks the means and the resources to "redeem all money certificates printed with its name for that gold ounce". If it could do this it would not be an FR bank. It would be a fully 100% asset backed bank.
  All the FR bank does is make promises while relying on a hope that it will never be called on to make good on all its obligations. So long as that happy state of affairs continues all is well and the fraud may continue (for a time, but remember eventually someone has to pay for it and it isn't going to be the bank). The abiding danger for an FR bank is that horrible situation when two or more people show up with notes or certificates related to the same gold ounce! Luckily for FR banks everywhere the laws and regulations relating to banking and fiat currency are designed to avoid the need to honour their undertakings and promises.
  
  The modern FR bank is identical to the counterfeiter in that it will not redeem notes for gold anyway. Try it and see. Go to your friendly neighbourhood bank and ask for gold. The FR bank will only give you notes for notes, paper for paper, promises for promises.

  The trouble with FR is that every note that is unbacked with an asset is fraudulent. The scam works so long as people continue to accept the notes believing they have value. Of course the notes gradually lose value as more enter circulation (FR bankers never manage to avoid the temptation to issue yet more unbacked notes). When people eventually realise what has occurred they abandon the notes and look to other stores of value. They do this when they perceive the notes are not a good place to store value. This takes place slowly at first but eventually the process accelerates. In the end there is a devaluation or even a collapse. Where has the value gone? Who stole it away?

  An important thing to realise is that FR banking fraud erodes the value of people's savings and the purchasing power of the notes in circulation. This is a theft which directly benefits the owners of the FR bank, favoured office holders within the FR bank and certain of its favoured "clients" (cronies) at the expense of ALL other people (not only those poor fools who hold the notes but EVERYONE ELSE as well). It is exactly the same as the case with the private counterfeiter. He and his gang attain value at the expense of the "suckers" who end up with the notes "when the music stops" and the notes are "discovered". He and his gang benefit against everyone else as well (think about the fact that he is able to purchase goods and services that otherwise would have been directed elsewhere, think about the small but actual contribution he has made to inflation- all exactly as what the FR banking systems achieves). The extent he can get away with his deception is determined by the "quality" of his privately minted notes, how many he issues, where he distributes them and whether people wake up to his scheme. In other words it's about how well he manages the scam; same as for the FR bank.

  FR banking and counterfeiting are variants of the same crime; in the case of FR banking it is known as a long firm fraud. The difference between the private guy with his printer and the FR bank is that the FR bank is part of an institutionalised expropriation scam that operates on a massive scale. FR banking is protected by rules and regulations designed to perpetuate and protect the fraud. The private counterfeiter is a mere flea by comparison. So long as we have a nationalised banking system we will be stuck with the FR banking fraud and notes which continue to decline in value over time. This continuously robs most individuals active in the economy of a growing portion of their wealth. It forces a strategy of minimisation of cash holdings (which is often not ideal). It causes the misdirection of resources.

  FR banking would quickly fail were it legal to refuse central bank notes in favour of a fully backed private currency. One merely needs to read the legislation surrounding the nationalised FR banking system to realise how carefully the fraud has been set in place, enabled and protected.

  Tragic. Costly for all of us.

  Sione

  Published: January 18, 2006 4:52 PM

• Paul Edwards

  Sione's Quotable quote: "it's about how well he manages the scam".

  That's where it's at alright.

  Published: January 18, 2006 5:34 PM

• Logan

  Sione,

  “The modern FR bank is identical to the counterfeiter in that it will not redeem notes for gold anyway. Try it and see. Go to your friendly neighbourhood bank and ask for gold. The FR bank will only give you notes for notes, paper for paper, promises for promises.�

  Wow, really Sione? I was just about to cash in my dollars for gold when you saved me the trip. Thanks for clueing me in.

  In all seriousness though, your post details the perils of FR banking in a fiat money world. I’ve never denied that this is a dangerous combination and that it is a large scheme of appropriation by the banking cartel and their government enablers. Rather, my posts were in defense of FR banking (or what I think is FR banking) operating in a truly laissez-faire environment. An FR bank must redeem his notes in gold because in a true laissez-faire monetary environment, gold probably will be money (definitely not Federal Reserve Notes). If it doesn’t, then it will be in breach of its debt contract and can be sued. Counterfeiters, on the other hand, may have gold in their “reserves,� but their notes are not being presented as a valid contract because they have no intention of redeeming the note with gold. FR banks, static and visible as they are, will redeem in gold because that is their business: getting loans from depositors and extending loans to willing parties. When the loans come due from depositors and vendors (creditors), they pay them using revenues from their debtors. Gold goes in, gold goes out. It should be noted that where free banking was prevalent in a laissez faire monetary environment, such as in Scotland and Hong Kong, bank failures were rare (no bank failure between 1935-1964 for Hong Kong, according to a Cato study of that period comparing Hong Kong, Canada, and the US) and FR banking was the banking of choice by the population.

  As I’ve said, I don’t see where FR banking in a free monetary environment exhibits fraud and I don’t see much evidence in favor of it being an unstable or unfavorable system compared to regulated banking or 100% reserve banking (I think that since outlawing FR banking is a violation of the freedom to make contracts, 100% reserve requirements is a form of monetary regulation by government). When the Fed is finally destroyed and the right to contract is honored in money matters, FR banking will not disappear, but it will definitely be more restrained.

  Published: January 18, 2006 6:02 PM

• Paul Edwards

  “I guess I don't agree with the concept of money substitutes, for the most part. You either pay with gold or you pay with paper that says that the issuer owes you gold in the future [i.e. an IOU].�

  We’ve nailed the basis of our disagreement. If you were to take a more Misesian view of money substitutes, I think you would conclude that they are not IOUs but that they are rather claims to present money. Therefore issuing them in excess of reserves is in fact fraudulent. But in the non-Misesian view of checks as IOUs (which I don’t hold), I can see your position that FR lending is not fraudulent.

  Here’s Mises on money substitutes that can “at every instant and free of expense, be exchanged against money�:

  http://mises.org/humanaction/chap17sec11.asp

  “Claims to a definite amount of money, payable and redeemable on demand, against a debtor about whose solvency and willingness to pay there does not prevail the slightest doubt, render to the individual all the services money can render, provided that all parties with whom he could possibly transact business are perfectly familiar with these essential qualities of the claims concerned: daily maturity as well as undoubted solvency and willingness to pay on the part of the debtor. We may call such claims money-substitutes, as they can fully replace money in an individual's or a firm's cash holding... A money-substitute can be embodied either in a banknote or in a demand deposit with a bank subject to check ("checkbook money" or deposit currency), provided the bank is prepared to exchange the note or the deposit daily free of charge against money proper... What counts is the fact that these tokens can be really converted free of expense and without delay... The main thing is that every owner of a money-substitute is perfectly certain that it can, at every instant and free of expense, be exchanged against money.�

  Published: January 18, 2006 6:45 PM

• Yancey Ward

  Paul,

  I see your point, but I don't agree that this is fractional reserve banking. If the bank poorly manages its incoming loan repayments and new deposits vs withdrawls of any type, then it may default on the check your hypothetical borrower wrote, but the money supply has not grown- the check is worthless. Now if a central bank comes along and bails out the bank's poor business practice by putting newly printed money into the accounts to cover the deficit, then we have fractional reserve lending since the bank's loan portfolio now exceeds the total deposits.

  Now, you can argue that during the time of the purchase with the unbacked check, the check was an actual, temporary increase in the money supply, that reshrank once the check was revealed to be worthless. I take it that this is your point, and I must concede it to you. I agree that it is better to keep cash reserves that cover the entirety of demand deposits, extracting a service fee from the customers.

  Published: January 19, 2006 8:49 AM

• Yancey Ward

  Logan,

  Just to be sure where you stand, I wish to ask a question.

  A bank collects $1 billion in deposits and creates loans in the amount of $10 billion. Is this fraudulent or not?

  Published: January 19, 2006 8:53 AM

• Paul Edwards

  Hi Yancey,

  There are two sources of inflation of fiduciary money. The first and primary is the fed’s habitual creation of new reserves that it inflicts on the open market each week as it buys up (with checks against itself) more federal debt than it sells.

  The second source, which is the banking situation I lay out above, is the bank credit expansion that follows. In my example above, for completeness, we can assume that the initial $100 deposit is a deposit of new banking reserves; the result of a payment to a favored Investment Bank from the fed through FOMC operations. So the $100 deposit is inflationary, but notice that by day 2, based on these new reserves, there are bank deposits of not merely $100, but a total of $190. That bank is lending based on a 10% reserve rule. On day 2 then, due to an increase of $100 in reserves, there has been an increase in fiduciary money of $190. The bank itself has inflated the money supply by $90 via brand new credit expansion.

  While in the asset column, there is $90 in an IOU, which will in general, certainly be debt with a term of more than a day. On the liability side is a corresponding claim on cash: a $90 dollar cash deposit in a checking account. It is not a question of poor management of incoming loan repayments. The structure of this FR balance sheet is necessarily beyond management. There are cash liabilities completely uncovered by cash assets and this is an intentional condition set by definition of fractional reserves, through fraudulent creation of new deposits from the creation of longer term debt on the asset side of the sheet. So you end up with two customers with shared claims to $90 in cash (via their checking accounts) by day 2.

  Compounding this problem is the situation which I did not discuss, and to which you allude: this $90 of new deposits when spent and deposited in another bank, will result in another $81 in credit expansion. This process of credit expansion based on this new initial injection of $100 in reserves can ripple through the banks resulting in the multiplying effect of a factor of not 1.90 times new reserves, but rather of 10X inflation due to credit expansion (based on 10% banking reserves).

  However, my point was to show that the FR banking fraud, the embezzlement, and the state of intentional insolvency occurred on day 2 when the new bank loan was made, but was only revealed on day 4. Generally speaking, however, day four doesn’t happen and the fraud is not revealed via bank failure or fed bailout, but rather with the implied theft associated with coercive transfers of wealth and devaluation of people’s wealth held in dollar terms that FR banking presents.

  Published: January 19, 2006 11:39 AM

• Logan

  Yancey,

  It depends on what you mean by deposits. It would be fraudulent to create multiple money titles to money that is a bailment deposit. A bailment deposit is one that specifically bars the bank from lending against your deposit unless you sign a CD debt contract. So, to make it easier to understand, it is fraudulent to advertise a 100% reserve bank and then proceed to make unauthorized loans.

  I define all other "deposits" at a bank to really be debt contracts where the "depositor" is really a creditor of the bank. I define it this way because the depositor gets interest payments on his or her money, either in the form of cash or free services that they otherwise would have to pay for (debit card, free checking, free security etc.). Also, I believe that the bank would have to make the contract a debt contract for their lending practices to be legal. I admit that this debt looks like a demand deposit, and it just might be for economic analysis, but in legal terms, I would call it a loan that is recallable instantly by the depositor (though the bank will probably add a call option to the depositor's funds to prevent withdrawal in the event of a cash shortage; the bank would then agree to pay an extra interest surcharge for the duration of the option's exercise). Thus, if this is a loan to the bank, then the bank is free to use this money as it sees fit, because it is the bank that has legal title to the money as long as the depositor leaves it at the bank. There are no multiple claims to money being loaned by the bank because the depositor signed over the title to the bank of all deposited funds.

  Paul,

  The answer to your last post to me about Mises's definition of money substitutes is embedded in my response to Yancey. In it, I said:

  "I admit that this debt looks like a demand deposit, and it just might be for economic analysis, but in legal terms, I would call it a loan that is recallable instantly by the depositor..."

  I believe that I hold a Misesian view of money substitutes, but that it only applies to the area of economic analysis. I agree that a check, money certificate, or debit card purchase can "at every instant and free of expense, be exchanged against money" in an economic sense. But in the legal sense, I think that checks, money certificates, and debit cards are IOUs because at the instant time of purchase of the good, the real medium of exchange (gold) does not change hands. Rather, the money substitutes constitute a debt claim against the bank that the store must, by definition, redeem in the future (even one millisecond in the future is still the future).

  I think my analysis is right on in terms of the economic and legal implications of dealings with an FR bank. The consequences of such definitions, though, are probably borne out in the Austrian theory of the business cycle. FR banks, legally able to loan in excess of their reserves by structuring their contracts as debts instead of bailments, initiate inflationary booms that lead to the malinvestment of higher order goods, which leads to an eventual bust and correction. I'm not quite sure if this is correct, but I believe that while Rothbard was against FR banking and for 100% reserves, Mises was a free banking advocate and saved his criticism of FR banking on their economic effects.

  So, in conclusion, I agree with you and I don't agree with you.

  Published: January 19, 2006 12:12 PM

• Paul Edwards

  Logan,

  Fair enough. You certainly do have on your side (controversial speaking) that the state deems FR lending to be legal and checking accounts are debt rather than bailment.

  On the other hand, it is the nature of state law that motivates me to distinguish between what is legal and what is ethically right. But this has been a good discussion. I can never resist a contest over the validity of FR banking.
  

  Published: January 19, 2006 1:00 PM

• Yancey Ward

  Logan,

  My example is one of fraud with which you seem to disagree. There are not multiple claims to the money in the bank since the bank explicitly created the money to loan out, however, the additional money that has been created is not backed by real savings (the bank's loan portfolio is larger by a factor of ten to its total savings deposits), thus the bank has created multiple claims to these, which were the basis for the original deposit. It creates inflation, and inflation is theft.

  Published: January 19, 2006 1:23 PM

• Sione Vatu

  Logan

  The fraud in FR banking exists at the point where the bank issues notes that are unbacked by reserves. Once this behaviour occurs the bank is no longer capable of meeting its obligations. It is defrauding not only the people who hold notes (whose purchasing power is being steadily reduced) but every other person as well (they are competing for goods and services with individuals/organisations who are bidding up "prices" using the FR bank's unbacked notes- the FR bank's actions are being paid for by a compulsory expropriation from all). The actions of the FR bank give it free credit at everyone else's expense. That is a theft and it certainly should (and would) be prohibited in a free economy.

  A FR bank issuing unbacked notes is like issuing bad cheques. This happened in the village a while back.

  Villiami had $50.00 in his cheque account. He paid the rent with a cheque for $50.00. Then he went to the shops and got the groceries, issuing another $50.00 cheque. Next Villiami headed off to the pub and sucked back $50.00 worth of grog (also some crisps and a meat pie), paid by writing another cheque for $50.00 or so. Then he figured he'd drive the car to the gas station and put $50.00 petrol in the tank. He topped up two 40 gallon drums with the stuff as well. This was for his boat. Paid for that lot with more cheques. In each case everyone was happy. Everyone got paid. He had clear intention to pay and properly issued his note (the cheque) to each person he did business with.

  Now so long as all those fellows down at the village stayed away from the bank (which is in town on the big island about 40 miles away) and did business with each other by endorsing Villiami's cheques (exchanging them as money) all was OK. Villiami went about writing cheques. So long as everyone stayed in the village and didn't go to town to see the bank that was not an issue. Eventually Villiami's cheques were in circulation throughout the village. They got endorsed over and again. All OK so far. No one hurt, right?

  Each time Villiami writes his cheque he knows there is $50.00 in the account so he should be OK. So he kept going. Hard to say if he was being a turd or if he was plain pig ignorant. Villiami was a fractional reserve monster!

  After a while there were quite a few Villiami cheques out and about. It was when more than one of the people from the village tried to clear a Villiami cheque at the bank on the big island that there was some trouble. The first fellow was OK. He was happy and for a time knew nothing of Villiami's knavery (actually accepted another endorsed Villiami cheque a couple of days later). Everyone else remained blissfully confident for a time as well. But when they subsequently tried to present Villiami cheques, well then, a different story. The cheques were not honoured as there was no asset, nothing of value, to back them. Each of those people had been defrauded. Villiami got free value at their expense by defrauding them. Interestingly some of these people he had not done business with (the cheques were endorsed).

  As the result of Villiami's antics all cheques were (and are) refused by villagers at Vasawa. Everyone got hurt. Consider that there was stuff that people could not get for an extra fortnight because Villiami got to it first. We all had to wait for the next ferryboat delivery. For instance, Mama Jay did not get her Vanity Fair magazine because Villiami got the last one in the store. Papagee ended up having to pay more for his gasoline since the fraud meant that Ratu refused everyone credit and the next shipment of gas was marked up to a higher price (Ratu recovering his loss and being plain angry I reckon). Villiami's family got it in the neck a bit as well. His sister was most upset by the whole situation.

  In the case of an FR bank the fraud is far better managed than Villiami did. It is on a far larger scale as well. In essence it relies on the same principle (just as with the counterfeiter). V's bad cheques produced damage that was limited and local. The fraud soon came to light and relatively few people are injured. In the case of an FR bank the damage is much more widespread and serious. It occurs over a longer time scale as well.

  Assuming a free economy, the officers of an FR bank would eventually find themselves in the same position as Villiami, the passer of bad cheques and counterfeiters and other fraudsters- in jail (Villiami got a pretty severe hiding and he still has to use a walking stick). There are several reasons.

  Freedom to enter a contract does not allow one of the parties to commit a fraud on the other. As sson as the fraud is detected, all bets are off. The contract has been broken or even invalidated. It may even be held to be void from the outset.

  A FR bank will ultimately fail when confronted with competitors that are 100% backed. For example, if I run a fully backed bank and you run a FR bank, my strategy is going to be to present any of your bank notes received at my bank to your bank and demand the gold immediately. Soon enough the FR bank will run out of gold reserves. Then the FR bank will default and you are in some deep trouble just as Villiami was; probably headed for imprisonment. Just think of all those people out there who wake up one morning and discover all those notes are worthless. Think of people who had accepted substantial payments (like for a house) in FR notes! What about those who had invested or piled their savings in the FR bank. All gone! Shit oh dear. I reckon they'd be well annoyed and you'd be lucky not to be lynched. They'd be on pretty solid gound to surmise the FR bank had committed fraud.

  For a tiny cost (in the end only as little as a few hundred dollars) the 100% backed bank has seen off the FR bank competitor for good. What has happened here? A fraud has been exposed.

  Freedom to contract does not imply freedom to steal, expropriate, cheat or defraud. FR banking is fraudulent. Say no to it!

  Sione

  PS When Villiami got a severe talking to by the town bank on the big island he volunteered to pay the debt off by writing them another cheque! That way he claimed they could honour all the cheques in circulation... Don't laugh, FR banks and central banks do this all the time. Villiami should run the Fed.

  
  

  Published: January 19, 2006 4:52 PM

• Logan

  Sione,

  "The fraud in FR banking exists at the point where the bank issues notes that are unbacked by reserves. Once this behaviour occurs the bank is no longer capable of meeting its obligations."

  Yes, if all of its obligations managed to come due at once. But all its obligations are coming due at different times. In the meantime, their loans are coming in with the interest income and they use it to pay off its obligations, whether it be to depositors, vendors, and its employees. The point is whether (once again) the bank can pay off all its current obligations according to the contracts it signed. I'm wondering Sione, am I committing fraud because I have consumed a home, school tuition, a car, and other miscellaneous goods while not having the means to pay back all these mortgage, loan, and credit card obligations all at once? After all, my obligations outstrip my cash reserves, so I must be as horrible as those FR banks. So, too, are the 99% of people who cannot shell out cash up front to pay for a house or car. According to your definition of fraud, all loan agreements would be deemed fraudulent.

  Villiami is not like an FR bank because he could not meet his current obligations with his available reserves. Let's say that Villiami wrote two $50 checks to two different vendors backed only by his current $50 in reserves, but he postdates the second check for next month. The first check clears, leaving him with $0 in his account. He gets paid $100 two weeks later, and two weeks after that, the second check clears, leaving him with $50. Now, according to you, Villiami was promising $100 to two different vendors with a reserve of only $50. But the way that the debts were structured allowed him to honor both contracts because he used current income to meet current debts and future income to meet future debts. This is not fraud. It is debt management that everyone in the world must use to get anything big, such as a house, or they use it when they buy things with a credit card. I might not have $400 for a new XBox, but I'll put it on my credit card and pay it off over time according to the contract I have with Visa. Villiami's bad check writing amounts to an uncollected debt that those store owners are entitled to according the debt contract. This means they are legally entitled to garnish his wages to collect his debt or Villiami could be forced to labor until the debt is paid. He broke a contractual agreement and should be punished. But FR banks, to the extent that they pay all the bills when they come due, violate no contractual agreements and are not liable for punishment.

  Published: January 19, 2006 5:43 PM

• Paul Edwards

  Sione,

  That story was just plain hilarious. You've also told it in such a way as to strike me that it may actually have happened. Did it or am i just gullible? Thanks for the huge laugh in either event.

  Published: January 19, 2006 5:44 PM

• Mike Sproul

  Paul:
  Besides the paper money issue by Massachussetts in 1690, there had been another issue of paper money in 1685. The story was that a French fort in modern-day Canada was delayed in getting a shipment of silver coins (livres) to pay its soldiers. The intendant, Jacques Demuelles, paid them with paper IOU's which were to be redeemed for silver when the coins arrived from France. Since they had hardly any paper, Demuelles wrote out the IOU's on playing cards. Those cards, of course, were backed by the silver that (they hoped) was in transit.

  Logan is right that fractional reserve banking is not fraud. Banks can issue dollars in the form of paper dollars, checking account dollars, credit card dollars, or whatever. As long as every dollar is issued in exchange for a dollar's worth of assets, the bank will always have adequate assets to back every dollar issued. It is irrelevant whether the bank can always redeem every dollar in gold on the spot, especially when the bank openly declares its intention to operate on fractional reserves.
  My latest paper on the subject, entitled "There's No Such Thing as Fiat Money" explains this.
  www.geocities.com/sproulmike/nofiatmoney122205.doc

  Published: January 19, 2006 9:33 PM

• Peter

  What do you mean by "a dollars worth of assets"? Are we now going into monetary-crank mode, where "money" can be any asset you like? If you mean "a dollars worth of gold" (or whatever single asset class you choose to use as money), what you're describing is a 100% reserve system - the gold represented by each note is all there in the vault. If you're doing the crank thing, you're basically saying there is no money, just indirect barter with whatever "assets" back your particular notes (which will constantly change in value wrt notes backed by other things, of course), but you also don't have a fractional reserve system.

  Published: January 19, 2006 10:33 PM

• Mike Sproul

  An example of "a dollar's worth of assets":

  ...ASSETS.................LIABILITIES
  1) 100 ounces of silver...100 paper dollars
  2) IOU worth $200.........200 paper dollars

  In line 1, the bank accepts 100 ounces of silver and issues 100 paper receipts called dollars in exchange, each declared to be convertible into 1 oz. of silver during business hours.
  In line 2, the bank prints 200 more paper dollars and lends them to a farmer who offers to repay $220 in 1 year (PV=$200 at R=10%). An IOU worth $200 is adequate backing for 200 paper dollars. (This is what I mean by "a dollar's worth of assets".)
  Now, even if all 300 paper dollars are presented at once for redemption in silver, the bank can honor its commitment by selling the $200 IOU for 200 of its own paper dollars and destroying the paper dollars collected. Then there are only 100 paper dollars outstanding, which can be redeemed for the remaining 100 ounces. At no point in this process does the dollar fall below 1 ounce, and at no point is any fraud committed.
  

  Published: January 20, 2006 12:07 AM

• Alan Dunn

  Congratulations I see that Ricardo's treasury view is still alive and kicking.

  The ricardian equivalencey argument rests on some pretty invalid assumptions peoples.

  fixed exchange rates, non-fiat monetary system, no derivatives.... and so on.

  Remove any of these assumptions from your analysis and the Ricardian equivalency argument crashes and burns.

  Mr. Nugent's article that Stefan mentions assumes flexible exchange rates, fiat money standard issued by a monoplolist supplier (FED through arrangements with government) and the existence of near monies such as derivatives.

  If these assumptions in Mr nugents model are indeed correct then there is absolutely nothing wrong with his analyis.

  However, if the Fed/government, and the economy as a whole are different to these assumptions then Mr Nugents analysis only applies to a fictional case.

  Perhaps the biggest consequnce of these assuptions by Nugent is that while government bonds are interest bearing they are a substitute for the base money issued by the FED.

  Therefore he assumes that becuse the bond is denominated in terms of the governments / FEDs own money the government has no budget constraint in terms of its own money (Yes its own Money - the FEd and the government may not be a marriage, but they do sleep together).

  If this is true then the role of bonds for government spending is not to finance the deficit; but as a tool for reserve maintenence.

  Example: The government issues a cheque with the FEd to pay for a good. The FED debits the account of the government and credits the bank account of the seller.

  Now the government do not issue the bond to finance the spending. Why would they need to? The bond and the base money are substitutes. the issue of a bond like the creation of base money are not financially constrained - their is a constraint - but its not in terms of the governments / FEDs money.

  The bond is used here for a completely different reason. What happens is that the deal between the FED and the government has increased the money base. Transactions between other banks and the FED and so on do not increase the money base - they are what we could describe as leveraging activities.

  OK OK but we wanna know about the bond. Ok then the increase in highpowered / base money leads to a sytem wide excess in the xchange settlement accounts held at the central bank. This increased liquidty places downward pressure on the target cash rate that was set by govet/ FED - who ever.

  These accounts held by banks only earn a minimal return , so they are more than willing to accept an interest bearing alternative. So the bond is given, liquidity reduced, the excess is effectively destroyed at the stroke of a button, and the FEDs/ whoevers target rate is maintained.

  Plese plese please, no loanable funds theory of interest rate determination here - your university lecturer lied to you - may have been me - but I was young and needed the money :0).

  OK Ok so why does Nugent think that deficits increase savings. Well first of all he has to assume that money demand is constant - if its not then he may have a point of bother.

  "If" the money base can only increase due to transactions between the FED and government then the only way to increase the money base is to increase government spending. Not saying this is true, just giving the required case for the example.

  Therefore, if the government runs a deficit the money base increases. If the government runs a surplus then the money base decreases because private agents must run down their savings / bonds to maintain their consumption.

  the usual consequnce when a surpluses are pursued is that eventually the private sector must resort to credit to when its savings run down.

  So in times of Budget surpluses (deficit) it would be argued that private sector debt increases (decreases) as consumption is fuelled by credit (savings).

  So is Mr Nugent correct - not exactly. Even if his implicit assumptions were true there is still the question of money demand remaining constant which is doubtful.

  But if we relax assumptions about money demand - it looks pretty good to me.

  As for taxes financing govenment spending this is a true but by no means a neccessay assumption. The most important question is "can a government fund its spending without taxing the private sector". Of course they can, they only tax for two reasons.

  1. to create an artifical demand for their otherwise useless money, that we need to pay our taxes; 2. They also use taxes to screw over the market mechanism so their socialist ideology remains dominant.

  Any refferences to Mises regression theory here need to take into account something very different today. The government / fed may control the money base, but they cannot control the money supply. This is because near money alternatives such as derivatives, securitisation, and so on severely effec the ability of the government/Fed to have complete control. Thus, it is possible that if we didnt have to pay taxes we caould resort to using forms of money other than those issued by the govet/FED. In the past this would not have been so easy because near money alternatives, and the technology we enjoy in banking today did not exist.

  Thus the conclusion - the government taxes only to create demand for its otherwise useless fia money.

  Where they get introuble is that the flexible exchange rate will soon show the errors of their ways. This is often the case why the FED go "apeshit" (technical term honest) intervening in markets to prop up or devalue the dollar rather than do the onest thing and let the market sort it out.

  My opinion is that I really don't care how the Govt/Fed operate. Just wanted to show how it might work under different assumptions.

  If the assumptions are wrong then the analysis is wrong. Must say though how impressed I am at peoples knowledge of the monetary financial sector given they know only what they have read from text books that assumed a fixed money supply, endogenous interest rate and fixed exchange rates, no derivatives, no securitisation, no monopolist supplier of fiat

  A very realistic model indeed :0)

  Published: January 20, 2006 2:17 AM

• Sione

  Logan

  The FR bank notes are redeemable on demand (not next week or next month but immediately- there is no extra time to search for the gold or for the bank to "earn" it). That is, the gold is payable immediately on presentation, instantly, today, right now! Should the bank not be able to meet this obligation for all its notes, then it has indeed committed a fraud. The fraud is compounded by the certain knoledge of the bank management, and executive, that there were insufficient reserves to back all the notes when they were issued in the first place. It matters not that the FR bank is betting its survival on the non-occurance of what it hopes to be a low probability event (sufficient notes being presented to exhaust its meagre reserves). The fraud is already there. The crime has already been committed. FR bank has issued notes that it promises to redeem for gold which it knows does not exist. Fraudulent. A lie.

  As with other criminal enterprises, the perpetrator (FR bank) hopes he or she (or they) won't get discovered and caught. It all hinges on a hope that they can get away with it, that the unthinkable disaster won't occur. The ability to evade being caught out (for a time or even for a very extended period of time) is not a valid defense for the commission of a crime. The crime is already present, it's simply a matter of when it becomes evident.

  Note what would happen to the FR bank in a free economy when faced with competition from a fully backed bank. Detection is certain and retribution swift (and likely to be ruthless).

  Your mortgage and other borrowings are not the same as the FR bank scam unless you borrowed at the outset knowing you would not be repaying your lender back as agreed. That would be negotiation with dirty hands (and an unclean mind as the Matai used to say). Fraudulent and deceptive conduct. Badness.

  In the case of a mortgage the lender and the borrower agree to a repayment schedule over time. Fair enough. I note that in any mortgage document I have been a party to, the lender reserves the right to call the loan (demand immediate repayment) prior to maturity (although there USUALLY has to be a good reason to so do). Should the borrower not be able to come up with the cash the lender may exercise a right to reposess the house (or whatever asset). The lender has security. In other words the borrower's "note" (or promise or undertaking) is backed. There is a big difference between this arrangement and Villiami's FR cheques, let alone the notes of a FR bank. So as I understand your circumstances you are not being naughty in your borrowing and certainly not fraudulent as an FR bank necessarily would be.

  Another point we should bear in mind is the FR bank fraud does not solely affect the holders of its shonky unbacked notes. Everyone else is defrauded as resources are bidded away from them by the free money (unbacked purchasing power) being distributed by the FR bank.

  Regards

  
  Sione

  Published: January 20, 2006 4:38 AM

• Sione

  Hello Paul

  Yes, it certainly did occur. Looking back at it now (years later) from a different country (I'm in Australia these days) it does seem pretty funny to me as well. Of course at the time it was pretty big news and very serious (especially for Villiami and his extended family).

  In a sense it was a tragedy. It eroded people's trust in each other and things were permanently changed. I sometimes wonder what could happen should the fiat money system and all the FR bank chicanery collapse. It wouldn't be a case of simply giving Villiami a thrashing and putting him to work paying off his debt. Can't blame him this time around.

  Guess all you can do is laugh!

  Best regards

  Sione

  Published: January 20, 2006 5:05 AM

• Michael A. Clem

  I'm getting some pretty mixed messages, here. Still not sure what fractional reserve banking is, but it seems to me that fraud occurs if dollars are issued that are not backed by assets, and that people *don't know* that there are no assets to back up the dollars. If people are aware that the dollars have no assets backing them up, and still choose to use them, then no fraud has occurred, although it's still a pretty shaky financial situation.
  
  
  Villiami committed fraud because people thought that there was money in the bank to cover all his checks, and not merely because he wrote unbacked checks.
  
  
  Despite Mike Sproul's example, an IOU is an unbacked promise. It only counts as an asset if someone is willing to buy it as an unbacked promise. Or rather, it's backed by the borrower's promise to pay it back. The IOU is only as good as the borrower's faith and credit.
  
  
  Thus, this goes back to a comment I made some time ago. Theoretically, nothing's wrong with fiat money as long as people accept it as money unbacked by assets. Everyone would be passing around IOU's that are backed simply by someone else's promise to pay them back. This wouldn't be fraudulent, although I do think that in general, people would prefer dollars backed by already-created assets, not promises-to-pay, which are essentially promises to create assets.
  
  
  Naturally, the complications are that the US government reserves the right to create currency and makes it 'legal tender', and I'm not sure most people know or care enough about economics to worry about the 'fiat-ness' of the currency. Even if an economic disaster strikes, it's not obvious that people would understand how fiat currency contributed to the problem.

  Published: January 20, 2006 11:05 AM

• Paul Edwards

  Michael,

  “Still not sure what fractional reserve banking is,�

  Don’t stop until you do understand it because that is prerequisite to deciding on whether it is fraudulent or not.

  “but it seems to me that fraud occurs if dollars are issued that are not backed by assets,�

  That particular fraud was institutionalized in America in 1913 with the fed and then reinforced by explicit theft of gold assets in 1933. However the question of FR banking can be narrowed in scope to today’s context to this: fr banking fraud occurs if claims to dollars are issued in excess of dollars held. That is, when a bank holds $100 cash, and creates checkbook deposits of $190, it has issued claims against (ownership title to) dollars in excess of dollars it holds or that actually exist.

  “and that people *don't know* that there are no assets to back up the dollars.

  “If people are aware that the dollars have no assets backing them up, and still choose to use them, then no fraud has occurred, although it's still a pretty shaky financial situation.�

  This statement means we are agreeing to define IOUs as money. Beyond being shaky, the problem is that this proposal states that we can agree to a definition of what money is that is a priori, in fact, not what money is and can never be. It’s a contradiction. We cannot, without contradiction of the laws of human action, simply agree that money is an IOU. Money, according to the laws of praxeology is of logical necessity, not by convention or historical empirical observation, a present good and not an IOU. Money substitutes are necessarily present claims of ownership in money. Therefore, issuing multiple claims to ownership in the same money (a present good) is necessarily fraudulent.

  As presented by Shostak at http://mises.org/daily/1118,

  On this Mises wrote,

  “It is usual to reckon the acceptance of a deposit which can be drawn upon at any time by means of notes or checks as a type of credit transaction and juristically this view is, of course, justified; but economically, the case is not one of a credit transaction. If credit in the economic sense means the exchange of a present good or a present service against a future good or a future service, then it is hardly possible to include the transactions in question under the conception of credit. A depositor of a sum of money who acquires in exchange for it a claim convertible into money at any time which will perform exactly the same service for him as the sum it refers to, has exchanged no present good for a future good. The claim that he has acquired by his deposit is also a present good for him. The depositing of money in no way means that he has renounced immediate disposal over the utility that it commands.�
  

  Published: January 20, 2006 12:01 PM

• Michael A. Clem

  I guess I'm just not a very original thinker, but I'm sure it doesn't help that the Mises site doesn't make things easy to look up except in the original source. Or is there a dictionary or index that I'm overlooking?
  
  
  I was forgetting my own, earlier insight, that wealth is goods and services, and that money is not wealth, but merely represents wealth. Thus, its use as a medium of exchange. Where currency is not backed by assets, i.e. wealth, currency is not money, but something that distorts or dilutes money, reducing its value as a medium of exchange.
  
  
  The Wikipedia article on money is quite interesting, and fairly concise, as well. It states that money has three essential characteristics: 1. medium of exchange, 2. unit of account, 3. store of value.
  It goes on to say that credit is not money because it only meets two of the three criteria. Under the criteria 'unit of account', it specifically says A debt or an IOU can not serve as a unit of account because its value is specified by comparison to some external reference value.
  
  
  Thus, if going by these criteria, an IOU cannot be considered money. Since fractional reserve banking creates loans based on IOU's instead of on assets, FR banking is undermining the value of money. It would be considered fraudulent because the unbacked money lent out is not, in fact, money. Assuming, again, that one accepts the three essential criteria defining money.
  
  
  I may not be original, but I can usually derive the logic or lack thereof of given premises. ;-)

  Published: January 20, 2006 1:24 PM

• Michael A. Clem

  I meant to include one last point to make sure I understand. If you were to buy a certificate of deposit from a bank for $100, then the bank could legitimately lend out that money, because you have the cd, not the money, though you expect to cash in at the end of the term for the money plus interest. But a bank could not legitimately lend out money that you put in a regular deposit account (checking or savings account), because that's still your money that you can draw upon, not a cd or some other kind of investment stock. The bank is just holding it for you. Correct?

  Published: January 20, 2006 1:49 PM

• Paul Edwards

  Michael,

  You sir, have it completely nailed. The CD is a great little savings device that is a real loan to the bank and they can in turn ethically fully loan those funds out; And in the meantime, we can be sure people won't be accepting your CD certificate as payment in cash for anything, because there will be no confusion on its status as a credit instrument. And so, it all remains on the up and up.

  On the side issue of finding things on mises.org, i am pretty incompetent. I'd like to know how to even find a three month old blog thread. I can't even do that. I use the mises specific search to find everything.

  Published: January 20, 2006 2:24 PM

• Yancey Ward

  Paul Edwards and Michael Clem,

  It might be useful to follow the implications of Michael Sproul's scenario.

  Lets say that I return to Sproul Banking with 300 Sproul dollars that promise to redeem the dollars for 1 ounce of silver each. Now Sproul has written that his bank can satisfy this by selling Farmer Ted's IOU for 200 Sproul Dollars, burning the dollars and exchanging the remaining 100 Sproul Dollars for the 100 ounces of silver. Now I assert that the promise has not been satisfied. For 300 Sproul Dollars, I did not get 300 ounces of silver, I got Farmer Ted's promise of 200 ounces of silver and 100 ounces of actual silver. Now, to make myself whole, I must go to Farmer Ted, present his IOU for 220 ounces of silver, but Ted doesn't have to pay until one year is up. However, lets suppose that Farmer Ted used his 200 Sproul dollars to buy seed from me (this is how I came into possession of 200 of the 300 Sproul dollars. OK so I can wait one year, but let us suppose that Ted is unable to pay 220 ounces of silver and chooses to default, so I repossess enough of Farmer Ted's assets to sell on the open market for 220 ounces of silver. I am now whole. Who has lost?

  Did the original depositor lose? He took his 100 Sproul dollars and purchased whatever is was he desired, and through different transactions, those 100 Sproul dollars came into my possession. The original depositor now has no claim on the 100 ounces of silver. So he did not lose.

  Did I lose? I now have 320 ounces of silver for the 300 Sproul Dollars I had in my possession. So I did not lose.

  Did Farmer Ted lose? He borrowed 200 Sproul Dollars, bought 200 ounces of silver's worth in seed, paid for it in 220 ounces of silver's worth in various assets. In essence, I gave him 200 ounces of silver's worth in seed for 220 ounces of silver's worth in his asset base. He is no worse off by going to Sproul Banking than we would have been if he had gotten the seed from me directly on a credit arrangement. So Farmer Ted did not lose.

  Identifying the loser is the key. If there was one, who was it?

  Published: January 20, 2006 2:58 PM

• MIchael A. Clem

  Yancey, I think you already addressed this in a previous post: In other words, it has created inflation, and it has defrauded all savers and consumers by devaluing their cash holdings.
  
  
  In Sproule's example, there were $100 dollars in geniune money, as defined by the three criteria, and $200 that was not geniune money. $300 in currency to represent $100 in actual wealth. The bank had loaned out $200 when it only had $100 on hand from the deposit.
  
  So that should answer your question, but it still doesn't answer the question about FR banking, though.

  Published: January 20, 2006 3:52 PM

• Yancey Ward

  Michael Clem,

  You may want to read the paper that Sproul wrote and provided the URL for (I have linked it below). It is an interesting read, and, as a noneconomist, I am finding it difficult to poke holes in it today. Was I correct to write that it caused inflation? Sproul would argue that as long as the IOU was backed by solid collateral (Farmer Ted's assets), then the 200 Sproul Dollars are also solidly backed, and that there can be no inflation. As I alluded to in my previous comment, Farmer Ted could have purchased his corn seed from me for 200 ounces of silver, assets worth 200 ounces of silver on the open market, or given me his IOU directly that promised 220 ounces of silver or its equivalent payable in 1 year. In the case of simply exchanging 200 ounces of silver's worth in assets for the seed, Farmer Ted and I have simply engaged in barter, while the other two scenarios are using silver as a medium of exhange, or we again engage in barter. In other words, there is only inflation if Farmer Ted's IOU is unbacked by assets in one year. Is it the case that in a backed money regime, inflation is caused by the certainty of default of a certain percentage of the borrowers who take dollars and leave IOUs?

  There Are No Fiat Moneys

  Published: January 20, 2006 4:18 PM

• Paul Edwards

  Yancey,

  The statement "as long as the IOU was backed by solid collateral (Farmer Ted's assets), then the 200 Sproul Dollars are also solidly backed, and that there can be no inflation" is necessarily false. If you attach any weight to the Austrian view of inflation, read the literature available here on mises.org to confirm in your own mind the incorrectness of Sproul's dramatically false position. You can turn to Mises, Rothbard, Hoppe, Block, and many other Austrians whose writings will confirm its falseness and explain clearly why it is false.

  An increase in the money supply is inflation period. An increase in the money supply by anything other than the minting of the commodity used as money is fraudulent.

  Fractional reserve lending increases checking deposits from thin air and so it increases the money supply. This may be a controversial question out in the world of Keynes. But in the world of praxeology, and true economics it is indisputably decided. It is definitely worth the investigation to see how the Austrians understand inflation.

  Published: January 20, 2006 5:08 PM

• Sione

  Yancey

  You presented the $300.00 worth of notes to the bank in order to get your silver right away. They (the FR bank) guarantee you the notes are redeemable for silver on demand (that is, on presentation). Yet the FR bank couldn't pay you for another one year from the time you presented their shonky notes. You are placed in the position where you have to invest your time and effort to chase up the farmer who, as it turns out, can't pay you for one year either. So you are placed in the position of bearing the risk inherent in the loan to the farmer; a loan you did not assess or negotiate. For your sake I hope the loan is sound and that the farmer is able to repay it (unlike the people at the FR bank who defaulted on their obligation to you).

  The notes were represented as being redeemable for silver. Three hundred dollars of silver you still do not have. What you have been given is part of your silver (1/3 of it), the hassle of tracking down the farmer to discover he can't pay for one year, the responsibility for the management and administration of a loan (of uncertain quality and risk- you'll now need to put in the research effort to discover the true nature of it) and an uncertain risk to bear. Notice that the bank has transferred their responsibility and risk onto you. All you wanted was your $300.00 of silver and that you still aint got and may not get. Good luck with it next year!

  There's worse news to come. If the farmer defaults guess who has to go to the effort of pursuing his assets and liqudating sufficient of them to recover the outstanding balance? You do. I'm betting that the time, overheads (legals etc.), heartache, stress, effort, opportunity cost (you could have been doing something better with your time) hassle and so on will mean that you'll end up short and out of pocket by some amount. You've lost value right down the line.

  Conclusion: Apart from anyone else, you lost. They lied to you.

  Sione

  Published: January 20, 2006 10:37 PM

• Mike Sproul

  The heartache and stress Sione mentions could easily be avoided if the bank takes adequate collateral. So let's say the banker lends the $200 to the farmer, and the farmer offers to let the banker hold $300 worth of his wheat until the loan is repaid (a pawnshop-style loan). If the loan isn't repaid the banker profits $100. No heartache (except to the defaulting farmer).

  The creation of new money needn't be inflationary if the new money is displacing barter or other forms of money, or if the new money just piles up in somebody's bank account. More to the point, saying that new money causes inflation is assuming the correctness of the quantity theory, which is the very point in dispute.

  If redeemability for silver bothers you, then let the bank declare in advance that it stands ready to redeem each dollar for one ounce of silver, OR to buy back dollars with the bank's IOU's.

  The creation of those $300 creates no inflation, and is not fraudulent. I can't help it if Mises & company didn't understand this.

  Published: January 20, 2006 11:32 PM

• Peter

  So let's say the banker lends the $200 to the farmer, and the farmer offers to let the banker hold $300 worth of his wheat until the loan is repaid (a pawnshop-style loan). If the loan isn't repaid the banker profits $100.

  How do you know? Wheat worth $300 at the time the loan is made might be worth $20 at the time it's defaulted on (in which case, this is an obvious incentive for the farmer to default rather than pay back $200 + interest). That's just one of the problems with this nutty idea of "backing" supposed money with something other than money - i.e., the idea that $100 can be issued in exchange for "$100 worth" of some other (non-money) asset like wheat or land or promises of future payment or 6 inch nails.

  Published: January 21, 2006 12:28 AM

• Paul Edwards

  “The creation of new money needn't be inflationary if the new money is displacing barter or other forms of money,�

  Mike,

  The creation of new money is inflation. The Keynesian ploy of confusing rising prices, which is a symptom of inflation, with inflation itself did not work on the Austrians. Honest commodity money displaced barter centuries ago. New fiat money does not displace barter; instead it has merely displaces honest commodity money. Money substitutes such as money warehouse receipts are sufficient if people wish to avoid dealing with coins.

  “or if the new money just piles up in somebody's bank account.�

  Creation of new money, inflation, will necessarily result in providing the receivers of this new money with the ability to bid up the price on the commodities they wish to buy. New money is not created for no reason, it is loaned out as it is created, and it is spent soon after it is borrowed. People borrow for the purpose of spending.

  “More to the point, saying that new money causes inflation is assuming the correctness of the quantity theory, which is the very point in dispute.�

  Creation of new money does not cause inflation, it is inflation.

  “The creation of those $300 creates no inflation, and is not fraudulent. I can't help it if Mises & company didn't understand this.�

  You are right. You could not have prevented Mises from failing to understand this. It is not your fault.

  Published: January 21, 2006 4:25 AM

• Yancey Ward

  Paul Edwards,

  I have read a lot of what you have recommended already during the RBD debates, I am partially playing Devil's Advocate here, and partially just trying to clarify my own thinking on this issue; and this clarification is aided by the ongoing debate.

  If the 200 Sproul dollars are solidly
  backed by Farmer Ted's assets, then the entire exchange with me reduces to a barter transaction. Now, Sione is correct that I have been tricked into this barter transaction by the lie of Sproul Banking, and that I will lose time and happiness in the process, but is this inflation? Is it fraud if Sproul Banking promises to redeem in silver or IOUs instead of silver alone? It seems to me that the inflation arises because of the increased supply on the market of the monetized assets; for example a lot of people like me are trying to sell tractors or wheat for silver, thus devaluing the IOU and the Sproul dollars being backed by them.

  Mike Sproul,

  Do you consider the US dollar to be adequately backed? What does the Federal Reserve back it with? If it is adequately backed, why do we see constantly rising prices? If it isn't adequately backed, then how would the Federal Reserve/US Government correct this?

  Published: January 21, 2006 8:32 AM

• Paul Edwards

  Hi Yancey,

  Fair enough. Then let's continue:

  “but is this inflation? Is it fraud…�

  Let’s answer the second first: “Sione is correct that I have been tricked into this barter transaction by the lie of Sproul Banking, and that I will lose time and happiness in the process�. So, YES. It’s fraud.

  Now for the first. It is an increase in the money supply, simple as that so YES, it’s inflation as well. The fact that this inflation comes about by monetizing debt even if backed by non-monetary goods, does not change this in the least.

  Mike’s position is basically this: The Austrian view on inflation and its relation to credit expansion is confused and wrong. My position is he’s confused, and wrong, and I’ve put my meager attempt at an argument for that position out already.

  So rather than me repeat my worn out arguments on why this is inflation, I challenge you to find any description of credit expansion or inflation in the Austrian literature that would lead in the slightest to conclude in Mike’s favor. We could discuss your interpretation of it.

  Assuming that to be impossible, find the most compelling argument in the Austrian literature that concludes against Mike’s position and dissect it yourself, showing that the Austrian position of equating an increase in the money supply to inflation is a wrong and or misguided or incomplete view. We could discuss that.

  I’m already convinced the Austrian view is sound and justified. Re-read the literature and tell me what you think.

  Published: January 21, 2006 1:31 PM

• Mike Sproul

  Peter:
  If the farmer's IOU falls in value then the dollars backed by that IOU will fall in value. There's no reason people wouldn't understand that bad things can happen, and they would still put their money in the bank with their eyes open. For that matter, if the bank had 100% silver backing, and the bank was robbed, then the dollars would lose value in that case too. Of course, the risk of robbery is much higher for silver than for IOU's, so it's easy to make a case for 100% reserve banking being more risky than fractional reserve banking.

  Paul:
  Saying that new money=inflation is like saying that issuing new corporate stock=falling stock prices. But we all know that as a corporation issues new stock, and gets equal-valued assets in exchange, there will be no fall in the stock price. The real-bills view (I hope you don't have the idea that I'm a Keynesian--eeew!) is that this is true of all financial securities--including financial securities that happen to be used as money.
  By the way: What if I go to my local grocer and I want a loaf of bread, which costs 1 oz. of silver. The grocer accepts my IOU, and he then uses it to buy supplies, and the IOU circulates as money. Would you call that fraudulent and inflationary? I wouldn't.

  Yancy: I'd say the dollar is actually overbacked. I remember that there's something like $3000 in currency per capita that has been issued by the Fed, while surveys show people hold about $100 per capita. Of course a lot of that is held abroad, but for the sake of argument suppose that the missing $2900 has been accidentally lost in fires, landfills, etc. That means the Fed has about 30 times more backing than it needs. The problem is that the real bills view says that the amount of backing per dollar specifies the MOST the dollar can be worth. But if the Fed chooses to conduct open market operations at a lower value, it can get away with it. That, incidentally, would be fraud.
  

  Published: January 21, 2006 7:54 PM

• Paul Edwards

  Hi Mike,

  “Saying that new money=inflation is like saying that issuing new corporate stock=falling stock prices.�

  Not quite. It’s more like saying that new money=inflation is like saying new corporate stock=more corporate stock. That’s more precise.

  Also, the issuing new corporate stock is done by the owners of the current stock. If the owners don’t want to issue the stock, they don’t. The influence of the new issue on the price of the current stock affects all stock holders equally, no one is benefiting at the expense of others.

  Secondly, the new stock is sold for money, which is claims on present goods that have already been worked for, backed by production, saved, and now made available for investment. The money provided to the company to spend on production comes from savings, not from new money printing.

  A way to introduce the FR banking influence to this scenario would be if the new corporate stocks were issued by the firm, and sold directly to banks which on adding these new stocks to its asset side of its spreadsheet, added on its liability side new checkbook deposits from thin air which it used to pay for this new issue. Now you have a pretty illustrative FR situation. How did the bank pay for the stock? By selling not dollars it earned by providing a good or service, but with dollars it created in its books. If only we private common schmucks could acquire assets with such a technique endorsed by the state courts, wouldn’t we all be happy? Except no, because the financial world would be in even worse upheaval than it already is with this fraud restricted as it is, only to the privileged banking industry.

  “What if I go to my local grocer and I want a loaf of bread, which costs 1 oz. of silver. The grocer accepts my IOU, and he then uses it to buy supplies, and the IOU circulates as money. Would you call that fraudulent and inflationary? I wouldn't.�

  The point where this IOU circulates as money is the point at which it is accepted as a money substitute i.e. people have been persuaded to believe it to be necessarily redeemable on demand for real money. To the extent that this belief is true is the extent to which this scenario is not fraudulent.

  If people do not believe it to be redeemable on demand for real money, they will not accept it as money, it will not circulate, and it will remain simply an IOU and the status of your transaction with the grocer remains a credit transaction. The grocer must wait for his money at the terms agreed and with risk and the wait will remain his unless he can actually sell that note to someone else willing to take the risk of the loan.

  But let’s consider real bills in this case: the real bills concept gets real hairy and wild: Let’s say the grocer tires of waiting for your money, and rather than trying to sell it to an investor who will trade his savings to the grocer for the note, the grocer instead sells it to his bank, who (common FR theme) buys the note, not with money it saved from producing and selling goods and services, but from creating a new checkbook deposit in its books. Then, again, yes we have inflation and fraud. Debt has been monetized, as they say. There is now more money in circulation. The bank has a new IOU asset in its books, and a corresponding cash liability created from thin air. This is fraudulent and inflationary.

  Published: January 21, 2006 9:46 PM

• Alan Dunn

  Hi Paul, how is there suddenly more money?

  1. my understanding is that this serves only as leveraging activity upon the existing money base (or high powered money issued by the FED/govt.

  2. I also thought (could be wrong though) that only trasactions between the government and Central bank could increase or decrease the amount of high powered money in the banking system (we can call them reserves I guess).

  3. All money (net holdings) we have in our possession whether it be an accounting entry or cash/coin is the result of "money creation" by a central bank. The fractional reserve system is merely leveraging activity upon the money base.

  Question: How can a commercial bank or business buy a bond if it has no free reserves or savings with which to make the purchase?

  Answer the government / central bank must run a deficit / create money ...there is no other way it can be done. No govt spending = no free reserves.

  The government / Central banks dealings create the money base, and it is from this money base that the fractional reserve system operates. No money base = no fractional reserves.

  So if the government / FED don't dreate money from thin air - where do we get our money from?

  We can't say governments use bonds to spend - unless we assume that free reserves automatically fell our way before the government actually created them. Without the free reserves we can't buy the bond.

  Few people realise this...I can't understand why.
  

  Published: January 22, 2006 3:27 AM

• GMB

  I might pick up on that one.

  "Hi Paul, how is there suddenly more money?
  1. my understanding is that this serves only as leveraging activity upon the existing money base (or high powered money issued by the FED/govt."

  But monetary base is not the only money. That part of the money supply which is not cash is called 'fiduciary money'. You might call it an 'on-call committment to supply cash'. And in practice it has the same effect on demand as the cash itself.

  Now its true that only the central bank can create cash. But the other banks can create fiduciary money.

  I'm not saying that they ought not be allowed to do this on the basis that doing so currently represents wicked behaviour. I would do so on the basis that the resultant system is such a hopeless one. And some would say the worm in the apple of modern capitalism.

  I, myself, would stop short of calling it fraud or larceny because it is many generations since any banker has worked under non-fractional reserve.

  But its just a stupid and unstable system. Which predjudices against metals and in favour of fiat, lends itself to political manipulation, slows down the transmission of information, and makes some Keynesian assumptions seem almost plausible to the laity.

  But it might be a better world if it were one day considered fraud again.

  Fraud and most grievous fraud.

  People point out that fiduciary money cannot be created except on top of the creation of cash. While this is technically true in practice the system as it stands is better understood by looking at it the other way.

  If an on-call committment is created then sooner or later it may need to be backed up by newly printed cash. The unpredictable nature of whether this happens or not and when strikes me as an obstacle to explaining how the bizzare system currently works. No-one is in a position to know when the truck is leaving the mint and where exactly its headed.

  The principle is that the creation of fiduciary money may at some stage call forth this cash.

  Published: January 22, 2006 5:38 AM

• Paul Edwards

  Hi Allen,

  “1. my understanding is that this serves only as leveraging activity upon the existing money base (or high powered money issued by the FED/govt.�

  My post on this thread at January 18, 2006 03:51 PM, gives the illustration of how fractional reserve lending increases the money supply. In that illustration, this inflationary event occurs on day 2 where the bank creates checkbook deposits of $90 from thin air in the process of lending that same $90 out. I have copied that part here:

  Day 1) We're good: depositor deposited $100 in checking account.
  ..ASSETS..|..LIABILITIES
  --------------------------------
  $100 cash.. | $100 checking deposit
  Day 2) Already fraudulent $90 loan is created here (10% reserve maintained).
  ..ASSETS..|..LIABILITIES
  ---------------------------------
  $100 cash...|.$100 checking deposit
  .$90 Loan...|..$90 checking deposit (thin air)

  This may be what you call leveraging, but it is also FR lending and it increases the money supply by virtue of increasing checkbook deposits by the amount of that $90 loan.

  “2. I also thought (could be wrong though) that only trasactions between the government and Central bank could increase or decrease the amount of high powered money in the banking system (we can call them reserves I guess).�

  Almost. Actually, the FOMC activity that occurs weekly is between the fed and certain favored financial institutions that have already bought these treasury securities in the past. The fed buys these older securities from there, but I think it is fair to say that economically it doesn’t matter if they buy direct from the treasury, or from a third party. Either way, it tends to keep demand up and interest rates down for these treasury securities. However, this way, it directly injects the new high-powered bank reserve money into the economy as you mention.

  “3. All money (net holdings) we have in our possession whether it be an accounting entry or cash/coin is the result of "money creation" by a central bank. The fractional reserve system is merely leveraging activity upon the money base.�

  Not really. More new money is generated via bank credit expansion through FR lending than is generated by the fed’s open market operations which creates the new reserves. It certainly is true that it is the fed’s continued open market operations that make it possible for the banks to continually expand the money supply via credit expansion. It’s a very synergistic operation. The banks depend on the fed to create new reserves, and the fed depends on the bank to expand credit based on these new reserves. It’s one big happy family I think is a fair thing to say.

  “Question: How can a commercial bank or business buy a bond if it has no free reserves or savings with which to make the purchase?�

  It can’t. The former requires reserves to create the new credit. The business just plain needs the savings. Of course, if the business borrows from the bank, it amounts to the bank requiring the necessary reserves. The fed actually penalizes the banks for being over-loaned up and having less than the legal required reserve limit.

  “No govt spending = no free reserves.�

  Actually, the fed is not constrained by necessity to buy government bonds to create new bank reserves. It just does it that way. I could just as easily accomplish the same end by buying stocks and bonds in Halliburton, Boeing, Anteon, and/or any other firm that sells securities in USD.

  “So if the government / FED don't dreate money from thin air - where do we get our money from?�

  To recap, the increase in the money supply comes from the fed’s FOMC operations which creates new (high-powered banking reserve) money and (to a larger extent) from the commercial bank’s credit expansion via FR lending.

  Published: January 22, 2006 7:49 PM

• Paul Edwards

  Sorry for misspelling your name, Allan. I meant to go back and double check it and then forgot!

  Published: January 22, 2006 7:51 PM

• Mike Sproul

  Paul:

  “Saying that new money=inflation is like saying that issuing new corporate stock=falling stock prices.�

  "Not quite. It’s more like saying that new money=inflation is like saying new corporate stock=more corporate stock. That’s more precise."

  We must be talking at cross purposes here. A rising money supply is one thing, and a fall in the value of money is another. Sometimes they have happened together and sometimes not, but they are not identically equal. For example, when the first paper money was issued in the American colonies, the new money displaced barter. There was much more money (obviously, since there had been almost none before) but there was little or no fall in the value of that money as more was issued.

  "Also, the issuing new corporate stock is done by the owners of the current stock. If the owners don’t want to issue the stock, they don’t. The influence of the new issue on the price of the current stock affects all stock holders equally, no one is benefiting at the expense of others."

  And new money can be issued by a bank that plainly announced its intention to issue it before it started business, and the bank's customers accepted the bank's money with full knowledge of this.

  "The point where this IOU circulates as money is the point at which it is accepted as a money substitute"

  The grocer accepted it as a money substitute. Is it fraudulent and inflationary at that point? I wouldn't say so.

  "But let’s consider real bills in this case: the real bills concept gets real hairy and wild: Let’s say the grocer tires of waiting for your money, and rather than trying to sell it to an investor who will trade his savings to the grocer for the note, the grocer instead sells it to his bank, who (common FR theme) buys the note, not with money it saved from producing and selling goods and services, but from creating a new checkbook deposit in its books. Then, again, yes we have inflation and fraud. Debt has been monetized, as they say. There is now more money in circulation. The bank has a new IOU asset in its books, and a corresponding cash liability created from thin air. This is fraudulent and inflationary."

  Either the customer's IOU circulates as money or the IOU is handed to the bank in exchange for the bank's IOU, which then circulates as money. In the first case the IOU is backed by the customer's assets, and in the second by the bank's assets. In neither case is there fraud or inflation.
  

  Published: January 22, 2006 10:29 PM

• GMB

  It may not be fraud. But it IS inflationary. And there are are perfectly viable plausible worlds possible where it WOULD be considered fraud.

  What's the problem here? We all know that it takes monetary base and fractional banking BOTH to produce a lot of extra money.

  Why try and put it all on one head when its a two-headed beast. People such as myself don't wish to go down to the local branch of the local bank and arrest all the lending officers. But its a stupid system. And you wouldn't lend your gold coins to the bank on that basis when there was fiat competition instead.

  The vast overwhelming share of the money supply is fiduciary money. On the other hand that fiduciary money does pyramid on top of printed cash money. Ergo its a two-headed beast. So why pretend otherwise?

  I would say there must be a problem going on here with regulating banks as an initiation of force. But one shouldn't let any such thing mess with ones monetary analysis.

  The key here is to think what the attitude would be if prices were dropping for the last 500 years under non-fractional reserve. And they charged to hold on-call deposits and paid interest on term loans.

  And if there were hundreds of different private coiners with different individual designs of coins in several metals. THEN if the banks lent out your coins while they were charging you to wharehouse them you most definately would consider it fraud.

  Published: January 23, 2006 12:01 AM

• Paul Edwards

  Hi Mike,

  “We must be talking at cross purposes here. A rising money supply is one thing, and a fall in the value of money is another. Sometimes they have happened together and sometimes not, but they are not identically equal.�

  What you are saying is entirely true. The thing you neglect to commit to is whether you think a rising money supply is inflation, or the fall in the purchasing power of money is inflation. I have said and maintain that, the former is inflation and the latter merely the symptom of it. You seem to think, although I have not noticed you commit to this position, that the latter is inflation. If this is so, you have been mislead by a magnificent Keynesian con and this would be the partial cause of us not connecting, and also the source, in my opinion, of your confusion.

  “For example, when the first paper money was issued in the American colonies, the new money displaced barter.�

  You are mistaken both from a theoretical and empirical perspective. From the theoretical, you are contradicting Mises’s regression theorem. From the empirical, it is well established that the United States was on a gold standard long prior to this fiat paper money system it has been on since 1913. Gold or silver money replaced barter in the world many centuries ago. Paper always only followed commodity money, and paper never directly replaced barter.

  “There was much more money (obviously, since there had been almost none before) but there was little or no fall in the value of that money as more was issued.�

  The only reason a general increase in the supply of money might not lead to an apparent rise in prices, as was the case in the 1920s, is because increases in productivity increase the demand for money concurrently with this increase in money supply. Without the rise in productivity, inflation would necessarily lead to increases in prices. Regardless, inflation of the money supply always tends to reduce the purchasing power of money in respect to what it would have been had the inflation not taken place.

  “The grocer accepted it [the IOU] as a money substitute. Is it fraudulent and inflationary at that point? I wouldn't say so.�

  The persistent theme in your argument is the conflation between credit and claim transactions. An IOU is not a claim on present goods and is therefore not a money substitute; it is a claim on a future good. The trade for the present goods, groceries, for the IOU was a credit transaction. Future goods do not and cannot function as money. Money is and necessarily must be a current good. The grocer lent present goods for the future good of the IOU. That IOU will not be able to function as money unless the community deems it a claim to a present good. If it is accepted as money, and hence as a present good and yet is not redeemable as a present claim for money, then it has been fraudulently misrepresented as a claim on present goods to those accepting it as money. The grocer, once again, did not take the IOU to be a claim against present money. Also, which I emphasize, a check is not an IOU: it is deemed to be a claim against current money.

  If that was as clear as mud, what I suggest is following these two links (there must be 100 similar ones on mises.org) which provide the typical Austrian description of the distinction between a credit and a claim transaction and the implication this difference has on money. Search on “transaction�, or “claim� or “credit� and you will come to more eloquent but hopefully essentially identical elaborations on what I am arguing.

  http://mises.org/daily/363
  http://mises.org/rothbard/austrianmoneysupply.pdf
  

  Published: January 23, 2006 11:03 AM

• Yancey Ward

  Mike Sproul,

  You sort of avoided my questions. So the US Dollar is "overbacked". So what is it overbacked with? If it is adequately backed, then what is the source of the undeniable inflation we see in the US?

  Published: January 23, 2006 11:44 AM

• GMB

  Yancey all that outside money is just more liabilities for the bank. Liabilities using the technical term for the bank and LIABILITIES for the country as a whole.

  If that money started coming in you would have to tax more than you spend and simply retire the cash to avoid very high inflation. Not retire debt mind you. Just retire the cash.

  Or they'd have to jack up the RAR which would actually be a good thing.

  The central bank has no backing whatsoever except as monopoly counterfeiter. Its hard to know quite what you were driving at.

  Published: January 23, 2006 6:27 PM

• Mike Sproul

  GMB:
  "It may not be fraud. But it IS inflationary."

  It's not inflationary on real bills principles. To repeat from my previous post:

  Bank A
  ...ASSETS.................LIABILITIES
  1) 100 ounces of silver...100 paper dollars
  2) IOU worth $200.........200 paper dollars

  
  Bank B
  ...ASSETS.................LIABILITIES
  1) 50 paper dollars.......50 checking account dollars
  2) IOU worth $100.........100 checking account dollars

  Bank A starts the fractional reserve process going by issuing 200 paper dollars in exchange for the $200 IOU. Bank B then keeps the process going by issuing 150 checking account dollars, each of which is, in effect, a call option on paper dollars. The real bills view of this loan expansion process is that neither bank causes inflation, since both have adequately backed the money they have issued. Just as call options don't affect the value of their base security, checking account dollars don't affect the value of the paper dollars. Still no fraud and no inflation. Every dollar is backed by assets worth one ounce of silver. The error of the Austrian view is that they insist that every dollar must be backed by silver itself, rather than something equal in value to the silver.

  Paul:
  "The thing you neglect to commit to is whether you think a rising money supply is inflation, or the fall in the purchasing power of money is inflation. I have said and maintain that, the former is inflation and the latter merely the symptom of it. You seem to think, although I have not noticed you commit to this position, that the latter is inflation. If this is so, you have been mislead by a magnificent Keynesian con and this would be the partial cause of us not connecting, and also the source, in my opinion, of your confusion."

  OK. I'll commit to defining inflation as a fall in the value of money. This same definition has been standard since way before Keynes came along, so I don't think I've fallen for any Keynesian falsehoods here.

  "it is well established that the United States was on a gold standard long prior to this fiat paper money system it has been on since 1913. Gold or silver money replaced barter in the world many centuries ago. Paper always only followed commodity money, and paper never directly replaced barter."

  I was talking about the colonial period, roughly 1690-1790, where barter was in fact displaced by paper money. Do a search for books by Curtis Nettels, Andrew McFarland Davis, and John McCusker, if you don't want to take my word for it.

  "An IOU is not a claim on present goods and is therefore not a money substitute"

  I buy a loaf of bread from the grocer with an IOU that I pay off in a few weeks. I bought the bread with the IOU. The IOU is money.

  Yancey:
  "You sort of avoided my questions. So the US Dollar is "overbacked". So what is it overbacked with? If it is adequately backed, then what is the source of the undeniable inflation we see in the US?"

  The dollar is backed by the gold and bonds held by the Fed, just like the dollars in my example above are backed by the silver and the IOU's. Inflation can be caused when the quantity of money outruns the assets of the issuing bank. It can also be caused when the issuing bank starts conducting open market operations at a reduced value. In my paper dollar example above, suppose an interest rate of 5%, and suppose that the bank suspends convertibility for one year. If people really want the silver, and the bank won't give it to them for one year, then the value of the dollar will fall to about .95 ounces. Thus the issuing bank can choose to conduct open market operations anywhere between .95 oz/$ and 1.0 oz./$. Anything less than 1oz/$ is inflationary and fraudulent, but could explain why we have had inflation even though the Fed does not seem to be losing its assets. This is explained in the same paper you downloaded above:

  www.geocities.com/sproulmike/nofiatmoney122205.doc
  

  Published: January 23, 2006 7:43 PM

• GMB

  Well it sounds like the 'real bills' view must be wrong then. Because if its an on-call committment for cash its fiduciary money and so part of the money supply. And adding to the money supply is inflationary.

  Now it may depend what one thinks normal is. I think normal is nominal GDP being more or less static and consumer goods prices falling all the time. Whereas if you think normal is price stability, and that the money supply ought to expand with real GDP then that's another thing.

  But consumer goods price stability doesn't imply monetary coherence, or good outcomes, or the avoidance of bubbles, or monetary stability, or stable aggregate demand, or the best of all possible investment markets..... well it doesn't mean any of those things.

  Quite the contrary.

  After all consumer goods prices were pretty stable in the 20's. And consumer goods prices were growing only slowly in the 90's. And because they were looking at consumer prices for arbitrary reasons, we get the crash of 29, and the runaway debt of the 2,000's.

  Published: January 23, 2006 8:33 PM

• Paul Edwards

  Mike,

  “OK. I'll commit to defining inflation as a fall in the value of money. This same definition has been standard since way before Keynes came along, so I don't think I've fallen for any Keynesian falsehoods here.�

  Nevertheless, you’ve fallen for a falsehood; I’ll not blame Keynes. Defining inflation as price increases was a con established by some class of individuals interested in focussing the masses on the effects of inflation and to keep them from actually understanding its causes. Defining inflation in terms of its symptom rather than the actual problem is only useful as a tool of confusion.

  “I was talking about the colonial period, roughly 1690-1790, where barter was in fact displaced by paper money. Do a search for books by Curtis Nettels, Andrew McFarland Davis, and John McCusker, if you don't want to take my word for it.�

  The time you are thinking of is described by Rothbard in “The Mystery of Banking�. The British and American economies were both on a well established commodity based money economy by that time. They certainly were not in a barter economy in 1690. See

  http://mises.org/mysteryofbanking/mysteryofbanking.pdf :

  “The first government paper money in the Western world was issued in the British American province of Massachusetts in 1690… It [Massachusetts] tried to borrow 3 to 4 thousand pounds sterling from Boston merchants, but the Massachusetts credit rating was evidently not the best. Consequently, Massachusetts decided in December 1690 to print £7,000 in paper notes, and use them to pay the soldiers. The government was shrewd enough to realize that it could not simply print irredeemable paper, for no one would have accepted the money, and its value would have dropped in relation to sterling. It therefore made a twofold pledge when it issued the notes: It would redeem the notes in gold or silver out of tax revenues in a few years, and that absolutely no further paper notes would be issued.�

  Just to recap: paper money didn’t directly replace barter here, nor did it ever do so in history. Study Mises’s regression theorem. It has a lot of insight to offer on how money evolved and the very nature of money itself.

  “I buy a loaf of bread from the grocer with an IOU that I pay off in a few weeks. I bought the bread with the IOU. The IOU is money.�

  Dig into some Mises sometime. You are odds with him on this very fundamental point.
  

  Published: January 24, 2006 12:03 AM

• GMB

  "the real bills view of this loan expansion process is that neither bank causes inflation, since both have adequately backed the money they have issued."

  What has that got to do with anything?

  Nothing.

  Its a strange ideology. It sounds like taking bridging credit and elevating it to the status of a major philosophy. If it adds to the money supply then its inflationary and since its fiduciary money supply its potentially deflationary. Because it can dissapear again in an unpredictable fashion.

  To repeat..... the two concepts are unrelated. Just because you think a bank is 'adequately backed' after the creation of more fiduciary money, and hell it may well be. But just because its adequately backed it does not mean that what it is doing doesn't add to the money supply. And if it adds to the money supply then its inflationary.

  ".... as call options don't affect the value of their base security....."

  Well that's debatable too. They ought to affect it. Because the owner of those call options will obtain possesion of the base security if the price of that base security rises above the call price during the option period. And then he may sell these securities at the current price pocketing the difference and helping drive the price down.

  ".. checking account dollars don't affect the value of the paper dollars...."

  This sounds like "As the potato grows on the highest branches, so too will the tomato roll up the sides of hills left unchecked."

  Published: January 24, 2006 1:33 AM

• Alan Dunn

  Hi Paul,

  Thanks for your input earlier Paul - I have a question . I'll paste your analysis below.

  "Day 1) We're good: depositor deposited $100 in checking account.
  ..ASSETS..|..LIABILITIES
  --------------------------------
  $100 cash.. | $100 checking deposit
  Day 2) Already fraudulent $90 loan is created here (10% reserve maintained).
  ..ASSETS..|..LIABILITIES
  ---------------------------------
  $100 cash...|.$100 checking deposit
  .$90 Loan...|..$90 checking deposit (thin air)

  This may be what you call leveraging, but it is also FR lending and it increases the money supply by virtue of increasing checkbook deposits by the amount of that $90 loan."

  Where does the $100 that was deposited in the first instance come from ?

  Surely its only source can be government spending or (gulp) money creation?

  Try the analysis assuming no savings or deposits exist in the private sector, and the FED and government are unwilling to intervene or spend?

  how will that effect the analysis?

  Sorry for my poor writing style, its very difficult to understand. But I really think the orthodox view of the monetary financial sector is a FERP = Flat Earth Research Program.

  
  Cheers.

  Published: January 28, 2006 11:51 PM

• Alan Dunn

  Hi Paul,

  Thanks for your input earlier Paul - I have a question . I'll paste your analysis below.

  "Day 1) We're good: depositor deposited $100 in checking account.
  ..ASSETS..|..LIABILITIES
  --------------------------------
  $100 cash.. | $100 checking deposit
  Day 2) Already fraudulent $90 loan is created here (10% reserve maintained).
  ..ASSETS..|..LIABILITIES
  ---------------------------------
  $100 cash...|.$100 checking deposit
  .$90 Loan...|..$90 checking deposit (thin air)

  This may be what you call leveraging, but it is also FR lending and it increases the money supply by virtue of increasing checkbook deposits by the amount of that $90 loan."

  Where does the $100 that was deposited in the first instance come from ?

  Surely its only source can be government spending or (gulp) money creation?

  Try the analysis assuming no savings or deposits exist in the private sector, and the FED and government are unwilling to intervene or spend?

  how will that effect the analysis?

  Sorry for my poor writing style, its very difficult to understand. But I really think the orthodox view of the monetary financial sector is a FERP = Flat Earth Research Program.

  
  Cheers.

  Published: January 28, 2006 11:57 PM

• Peter

  The original $100 came out of the ground (i.e., a gold mine)

  Published: January 29, 2006 6:20 AM