Comments (76)

• Mike Sproul

  Edward III defaulted on his loan, so the lending bank failed. And you blame fractional reserve banking? How about putting the blame on Edward III? Or even on the banker who was foolish enough to trust him? Yes, a fractional reserve bank can fail because of defaults, but a 100% reserve bank can fail if it gets robbed. At least with fractional reserve banking the banker earns interest on loans, and doesn't have to charge storage fees.
  

  Published: December 24, 2006 6:26 PM

• mike

  The text does not state that the Edward III default caused the banks to fail, only that it was a factor. The more significant factor is the withdrawal of deposits, which is the death knell of the fractional reserve system (the run on the bank) because the bank by definition does not have sufficient cash to pay all depositors. Not to mention the inflationary effects of fractional reserve banking, which brings with it the boom-bust cycle.

  Published: December 24, 2006 10:20 PM

• Mark Brabson

  If the banker wants to earn interest on loans, than let him encourage his customers to make timed deposits, rather than demand deposits. Money that is committed to the bank for a certain fixed period and money that the bank may freely loan out, with no fraud involve.

  I would happily pay a storage fee for demand deposits. A very small price to pay to enjoy an inflation free, commodity money economy.

  Also, I could insure my demand deposits against bank robbery. Obviously, the onus would be on banks to insure timed deposits, if they so wished.

  Published: December 24, 2006 10:32 PM

• George Gaskell

  Edward III defaulted on his loan, so the lending bank failed. And you blame fractional reserve banking? How about putting the blame on Edward III? Or even on the banker who was foolish enough to trust him?

  You are missing the difference between the failure of a single bank (due to the kind of errors and miscalculations that you describe) and the pervasive, economy-wide effects of fractional reserve banking.

  The two types of failure are not comparable. This is one of the first points in the opening pages of the Austrian Theory of the Trade Cycle. Mises referred to the existence of multiple failures, which you see in inflation-based busts, as "clusters" of failures.

  Isolated failures can be absorbed by healthy competitors, and are usually a form of opportunity (for everyone but those immediately affected, of course). A healthy economy accommodates these failures. But clusters of failure can only be caused by factors that are common to all of the businesses that fail. What they all have in common is the medium of exchange -- the money. When the money itself is distorted due to fractional reserve and inflationary booms, you get things like recessions and depressions. In these cases, malinvestment is so pervasive that the economy as a whole cannot accommodate such failures.

  Published: December 24, 2006 10:58 PM

• Sam

  I'm a lil confused here. If credit expansion causes booms and busts, then how does a simple gold-weight currency work instead? If there is a set amount of gold for currency how does the economy expand? It is a simple case of as more businesses appear, prices are supposed to go down? I'm not exactly sure what the incentive scheme is as prices go down, so do profits? Likewise if you lend money how would you get it back? You lend $100 and the get the $100 but prices are cheaper or something?

  Since I'm presuming that simple gold-weight currency is the supposedly suitable standard how does the economy expand? Some commentators have said that in times past there was only expansion when more gold was found . . .

  P.S. Merry Christmas! XD

  Published: December 25, 2006 3:05 AM

• eddy

  Yes, prices are supposed to go down. Tv sets, stereos, computers, etc go down in price, because of improvements in the productivity of labor. And these industries dont go into recession because of this. And money is lent to these industries.
  So, what is the problemn with falling prices?

  Published: December 25, 2006 4:29 AM

• Sam

  That doesn't make a great deal of sense. How are you supposed to tell the difference between prices dropping to due to greater productivity or simple depreciation? And how is this not a relativistic thingo of fixed currency/deflation versus variable currency/static-ish prices?

  Published: December 25, 2006 4:45 AM

• Björn Lundahl

  Sam

  What Has Government Done to Our Money?

  “Thus, we see that while an increase in the money supply, like an increase in the supply of any good, lowers its price, the change does not—unlike other goods—confer a social benefit. The public at large is not made richer. Whereas new consumer or capital goods add to standards of living, new money only raises prices—i.e., dilutes its own purchasing power. The reason for this puzzle is that money is only useful for its exchange value. Other goods have various "real" utilities, so than an increase in their supply satisfies more consumer wants. Money has only utility for prospective exchange; its utility lies in its exchange value, or "purchasing power." Our law—that an increase in money does not confer a social benefit—stems from its unique use as a medium of exchange.

  An increase in the money supply, then, only dilutes the effectiveness of each gold ounce; on the other hand, a fall in the supply of money raises the power of each gold ounce to do its work. We come to the startling truth that it doesn't matter what the supply of money is. Any supply will do as well as any other supply. The free market will simply adjust by changing the purchasing power, or effectiveness of the gold-unit. There is no need to tamper with the market in order to alter the money supply that it determines.”

  http://mises.org/money/2s8.asp

  Murray Rothbard:

  Myth 7: Deflation--falling prices--is unthinkable, and would cause a catastrophic depression.

  ”The public memory is short. We forget that, from the beginning of the Industrial Revolution in the mid-18th century until the beginning of World War II, prices generally went down, year after year. That's because continually increasing productivity and output of goods generated by free markets caused prices to fall. THERE WAS NO DEPRESSION, HOWEVER, BECAUSE COSTS FELL ALONG WITH SELLING PRICES. Usually, wage rates remained constant while the cost of living fell, so that "real" wages, or everyone's standard of living, rose steadily.

  Virtually the only time when prices rose over those two centuries were periods of war (War of 1812, Civil War, World War I), when the [p. 26] warring governments inflated the money supply so heavily to pay for the war as to more than offset continuing gains in productivity.

  We can see how free-market capitalism, unburdened by governmental or central bank inflation, works if we look at what has happened in the last few years to the prices of computers. Even a simple computer used to be enormous, costing millions of dollars. Now, in a remarkable surge of productivity brought about by the microchip revolution, computers are falling in price even as I write. Computer firms are successful despite the falling prices because their costs have been falling, and productivity rising. In fact, these falling costs and prices have enabled them to tap a mass market characteristic of the dynamic growth of free- market capitalism. "Deflation" has brought no disaster to this industry.

  The same is true of other high-growth industries, such a electronic calculators, plastics, TV sets, and VCRs. Deflation, far from bringing catastrophe, is the hallmark of sound and dynamic economic growth.”

  http://www.geocities.com/ecocorner/intelarea/nmr9.html

  In other words, in a free unregulated economy, selling prices generally will fall which also, therefore, will include business costs and this in turn will keep profit margins unchanged and businesses profits, therefore also, remaining the same.

  Björn Lundahl
  Göteborg, Sweden

  
  

  Published: December 25, 2006 7:09 AM

• Sam

  But what of depreciation? The first to buy risks watching their thingo price plummet. Indeeed the resale of computer parts tends to be pathetic with time, meaning that most would hold off buying or upgrading a computer until necessary. Goodness knows I do.

  Or hoarding? One would think in an age of gold-weights it would make sense to hoard gold under the pillow if with the passage of time your buying per ingot would grow over time and you wouldn't have any incentive to spend other for basic nessecities. This would cause an economic winter as the currency would be too rare and either some have to barter to make up for the shortfall in currency or wages would have to be lower to allow more people to have to something to spend with, maybe?

  Or what of lending? I would think lending would be hard to work if you could possibly got less back than what you lent in the first place.

  And what of the hard-start for deflation, as for inflation, where those who lower their prices risk losing out because others have yet to lower their prices? If there's a lag in inflation costs why not in deflation?

  Published: December 25, 2006 7:25 AM

• Björn Lundahl

  Sam

  People produce things because they want to consume.

  I bought an extra laptop “Acer 3103” just for fun and because it was cheap. I already had a laptop “HP nx7010”. This extra purchase was done because of deflation.

  The number of computers sold increases all the time.

  Americas Great Depression, by Murray Rothbard:

  “In a brilliant article on Keynesianism and price-wage flexibility, Professor Hutt points out that:

  No condition which even distinctly resembles infinite elasticity of demand for money assets has even been recognized, I believe, because general expectations have always envisaged either (a) the attainment in the not too distant future of some definite scale of prices, or (b) so gradual a decline of prices that no cumulative postponement of expenditure has seemed profitable.”
  If we want to imagine things we can also imagine this:

  “But even if such an unlikely demand arose:

  If one can seriously imagine [this situation] . . . with the aggregate real value of money assets being inflated, and prices being driven down catastrophically, then one may equally legitimately (and equally extravagantly) imagine continuous price coordination accompanying the emergence of such a position. We can conceive, that is, of prices falling rapidly, keeping pace with expectations of price changes, but never reaching zero, with full utilization of resources persisting all the way.”

  http://mises.org/rothbard/agd/chapter2.asp#liquidity_trap

  Björn Lundahl

  Published: December 25, 2006 8:15 AM

• Sam

  To Björn Lundahl:

  Are you sure you are not confusing depreciation and deflation? It could argued that with inflation some people benefit with their ability to charge extra with the inflationary increase whilst others are losers because they can't charge extra and have to bite the bullet. But can deflation benefit some and hurt others? Why not, in deflation, can't they pass their falls on to workers' wages and see if workers will have to take the loss? Indeed if inflation at times causes mere scalar increases, why not deflation cause scalar decreases?

  P.S. Could you use everday talk when explaining economic scenarios? Me don't understands fancy concepts necessarily . . .

  Published: December 25, 2006 8:23 AM

• Björn Lundahl

  Sam

  “P.S. Could you use everday talk when explaining economic scenarios? Me don't understands fancy concepts necessarily . . .”

  Explanation of:

  “But even if such an unlikely demand arose:

  If one can seriously imagine [this situation] . . . with the aggregate real value of money assets being inflated, and prices being driven down catastrophically, then one may equally legitimately (and equally extravagantly) imagine continuous price coordination accompanying the emergence of such a position. We can conceive, that is, of prices falling rapidly, keeping pace with expectations of price changes, but never reaching zero, with full utilization of resources persisting all the way.”

  If we can imagine that people could hoard enormously and that hoarding could, also, increase enormously all the time, we can also imagine that prices could rapidly fall to the same extent, the expectation of this enormous rapid increases of hoarding could also drive down costs enormously to the same extent and could, therefore, keep profit margins unchanged. Consumption and savings could remain the same. Full employment and full utilization of resources could, despite of all the enormous rapid increases of hoarding, still remain unchanged.

  
  Björn Lundahl
  

  Published: December 25, 2006 9:40 AM

• Björn Lundahl

  Sam

  “Or what of lending? I would think lending would be hard to work if you could possibly got less back than what you lent in the first place.”

  Lenders will get more money back (both in nominal and real terms) and not less i.e. they will earn interest.

  Deflation (defined as increase of the purchasing power of money)

  If the money supply is constant and prices on the average fall and this is also expected, the factors of production, land and labour will be discounted accordingly throughout the production structure (various stages of production) and capitalists will earn interest on their investments.

  For example:

  If a capitalist makes an investment of 100 million dollars (in gold) in real estate, and is happy with 5% net profit yearly when the purchasing power of money in society is zero, this happiness will be maintained, logically, if the same capitalist makes an investment with 5% net profit yearly plus a premium of the value lost per year of the initial investment in real estate when the purchasing power of money in society is increasing. This premium is brought about by purchasing the real estate in question for a price of 90, 80, 50 million dollars etc or whatever price that fully compensates him for the value lost because of deflation.

  For further explanation, go to (Man, Economy & State):

  http://mises.org/rothbard/mes/chap11b.asp#5G._Purchasing_Power_Terms_of_Trade

  In an unregulated economy there is an overall expectation that prices will fall. Prices will fall, generally, probably quite stable with approximately the same amount of deflation, year after year.

  It is true that problems will initially be great and hard when the economy is adjusted from an inflationary economy to a deflationary. Better to not increase inflation in the first place. Now when we live in an inflationary economy the damage has already been done. This is a tough choice which we should make if we want to end business cycles and have real prosperity. An alcoholic will go through pain when stopping drinking, but if he really wants to end all the bad effects of being an alcoholic, he should stop drinking.

  Björn Lundahl

  
  

  Published: December 25, 2006 9:56 AM

• Dan Coleman

  On the "hoarding" problem:

  http://mises.org/money/2s9.asp

  (selections:

  "Is hoarding really a menace?

  In the first place, what has simply happened is an increased demand for money on the part of the miser. As a result, prices of goods fall, and the purchasing power of the gold-ounce rises. There has been no loss to society, which simply carries on with a lower active supply of more "powerful" gold ounces.

  Even in the worst possible view of the matter, then, nothing has gone wrong, and monetary freedom creates no difficulties. But there is more to the problem than that. For it is by no means irrational for people to desire more or less money in their cash balances.

  Let us, at this point, study cash balances further. Why do people keep any cash balances at all? Suppose that all of us were able to foretell the future with absolute certainty. In that case, no one would have to keep cash balances on hand. Everyone would know exactly how much he will spend, and how much income he will receive, at all future dates. He need not keep any money at hand, but will lend out his gold so as to receive his payments in the needed amounts on the very days he makes his expenditures. But, of course, we necessarily live in a world of uncertainty. People do not precisely know what will happen to them, or what their future incomes or costs will be. The more uncertain and fearful they are, the more cash balances they will want to hold; the more secure, the less cash they will wish to keep on hand. Another reason for keeping cash is also a function of the real world of uncertainty. If people expect the price of money to fall in the near future, they will spend their money now while money is more valuable, thus "dishoarding" and reducing their demand for money. Conversely, if they expect the price of money to rise, they will wait to spend money later when it is more valuable, and their demand for cash will increase. People's demands for cash balances, then, rise and fall for good and sound reasons."
  

  Published: December 26, 2006 7:53 AM

• Sam

  D. Coleman, that doesn't make obvious sense. As there is less money there are lower prices. . . A.K.A deflation? With more money around and higher prices -> inflation? Either way it's a scalar effect where the overall prices have changed but the purchasing power has gone nowhere.

  Published: December 26, 2006 8:22 AM

• Dan Coleman

  Sam,

  I don't think I understand. What exactly is the question / objection that you are raising?

  Published: December 26, 2006 8:42 AM

• Sam

  If inflation sooo bad, what's so good about deflation? Currency is supposed to be neither too common nor too rare. People keep whining about inflation but why would deflation necessarily be better? Chances are when prices fall so will wages/salaries anyway? So either way most people would probably be better off.

  Published: December 26, 2006 8:57 AM

• Mike Sproul

  Sam:
  The confusion is being caused by the quantity theory of money, which is wrong, as opposed to the real bills doctrine, which is right.
  A banker accepts 100 ounces of silver on deposit and issues 100 paper receipts (dollars) in exchange. The paper dollars can be used as money, and assuming the banker maintains convertibility at one ounce per dollar, each dollar will have a market value of one ounce of silver. It is clear that as long as every dollar issued is backed by an ounce of silver, any amount of dollars can be issued without causing inflation. It should also be clear that it is immaterial whether the dollars are issued as printed pieces of paper or as bookkeeping entries transferable by check or other means.
  Next, the bank lends $200 to a farmer. Assuming a market interest rate of 10%, the farmer might promise to repay $220—either in dollars or in goods of equivalent value—after one year. The banker could make the loan by printing and lending 200 paper dollars to the farmer. For his part, the farmer gives the banker his 1-year, $220 IOU, which is worth $200 today.
  

  The banker’s loan triples the supply of paper dollars. One might expect the value of the dollar to fall—perhaps to one-third of an ounce of silver. This is incorrect. No matter how many dollars are issued, each dollar remains worth 1 ounce of silver as long as the bank only issues a dollar for a dollar’s worth (or ounce’s worth) of assets. This can be demonstrated by assuming that the contrary is true. Suppose, for example, that the tripling of the supply of dollars caused their market value to fall to something less than one ounce of silver. The bank has promised to redeem each dollar for one ounce of silver, so holders of dollars will present them at the bank and demand one ounce of silver for each dollar. Since there are 300 dollars outstanding and just 100 ounces of silver in the bank, it might seem that the bank is unable to redeem all of the dollars it has issued. But in fact the 300 dollars are fully backed by the silver plus the $200 IOU, and the bank is capable of redeeming every dollar at par. For example, the bank could sell the $200 IOU for 200 of its own paper dollars. It could then destroy the 200 paper dollars, and be left with 100 outstanding paper dollars laying claim to 100 ounces of silver in the bank. The bank could then redeem each of the remaining 100 dollars for 1 ounce of silver. At no point in this process would the value of the dollar fall below 1 ounce of silver.
  

  Published: December 26, 2006 9:32 AM

• RogerM

  Sam:"If credit expansion causes booms and busts, then how does a simple gold-weight currency work instead?"

  I think there is some confusion among a lot of people that simply going back to a gold standard for money would solve all of our problems, when as this article shows, booms and busts have occurred for centuries when gold and silver were money. When the banks of Italy resorted to fractional reserve banking, they didn't increase the amount of gold or silver available, so in that sense the money supply didn't increase.

  But in addition to gold and silver, they used another type of money very similar to paper money, which was simple accounting entries. Rather than pay others with gold or silver, businesses would have the banker debit his account and credit the account of the other party. If a businessman got into trouble and didn't have enough gold/silver in his account to pay his creditors, the banker could loan him money by simply drawing a line through the old balance and writing in a new balance equal to the amount of the loan. This type of credit expansion increased the effective money supply without increasing the amount of gold/silver in circulation. Under 100% reserve banking, the banker would not be able to make a loan to a customer unless someone had deposited an amount of gold equal to the loan.

  "But what of depreciation?...Or hoarding?...Or what of lending?"

  You're right that if our money supply were fixed at a specific amount, prices would decline each year and that decline would be roughly equal to the increase in production. The impact on the economy would depend on the severity of the price deflation. Sudden or rapid changes would cause a lot of debtors to go bankrupt because the principle on the loan would increase dramatically. But a steady, low rate of deflation, such as 3%, would change the character of our economy in a major way. Instead of rising debt, as we now have, people would resort to debt only when necessary. Most people would save for future needs, whether they earned interest on the savings or not because their savings would grow at the rate of price deflation. We would switch from a debt driven economy to a savings driven one.

  But businesses would still borrow in order to expand as long as the expected profit is greater than the cost of borrowing, which would be the 3% deflation plus the interest rate. If the interest rate were 3%, then a borrower would effectively pay 6% for the borrowed funds. If he expected to make a 9% return on his investment, he would still find it profitable to borrow money and invest in new production.

  But Dr. Reisman in his book "Capitalism" doesn't think we would experience significant deflation under a gold standard with 100% reserve banking. The 100% reserve banking would effectively end boom-bust business cycles, but the increased demand for gold/silver money would spur technical innovation in mining and increase the supply of gold/silver by about 3% a year, so prices should remain reasonably constant instead of falling.

  Credit expansion causes several problems: 1) It causes business people to make mistakes in investing and waste resources. 2) It causes the boom-bust business cycle. 3) It redistriubutes wealth from the later receivers of the new money to the early receivers. Mainstream economists believe that everyone receives new money equally during a credit expansion, but that's naive. Austrians show that new money created through credit expansion goes to a few people who can buy assets at the pre-inflation prices. As the new money filters through the economy, it causes prices to rise. The last people to receive the new money pay the inflated prices for assets. Financial institutions, speculators, and the government are often the ones enriched by credit expansion.

  The housing market offers a good example. Before housing prices began to rise in the late 1990's, those who borrowed new money created from credit expansion could purchase housing at the pre-boom prices. Those who waited until 2005 to buy a house had to pay up to 50% more for the same house, with the profit going to the early investors who received the new money first.

  Published: December 26, 2006 9:36 AM

• Mark Brabson

  In a true commodity money economy there would not be monetary deflation. Initially, there would be a significant price deflation but that would moderate after the transistion from fiat money to commodity money. Thereafter, you would likely experience a very slight price deflation trend, which would affect both goods and wages.

  This is good for the average Joe on the street. His saved money would gain value over time, rather than being stripped of value by inflation. Because wage deflation would tend to lag price deflation, he would not be harmed economically. In fact, the common man would come out ahead.

  The only people that truly would lose out are at the very top end of the income spectrum, i.e. bankers and speculators. Without endless credit to drive up prices, you would rapidly see the end of the "super rich" class. There would still be wealthy people of course, as there should be. But these will be entreprenuers and people who invested capital in a sound venture.

  Anybody who is really sincere in wanting to help the small man should support commodity money and 100% reserve banking. That is by far the best way to do it.

  Published: December 26, 2006 10:31 AM

• Mark Brabson

  The other aspect of a commodity money, 100% reserve banking economy is the availability of credit. Credit will not be the easy thing people are used to today. In such an economy, most people would not be able to obtain credit cards and credit in general would be far less available. This would be a free market method of forcing people to live within their means. They would have to save in order to get the things they want, rather than instant gratification. There would be no boom, consequently, there would be no busts. Things like housing would be more in reach. Without expansionary credit to drive up home prices dramatically, home prices would drop, probably quite dramatically. Mortages, secured by a healthy down payment and by the house itself, would be easier to obtain, since the amount lent would be far smaller.

  Also, to clarify. It is primarily unsecured credit, such as credit cards that would disappear. Secured credit, such as mortages, etc., would be the primary form of credit available.

  Published: December 26, 2006 10:56 AM

• RogerM

  Mark,
  Good points! Price deflation would solve the social security and long-term care problems, too, because savings would increase at such a rate that people could provide for themselves in retirement and not be at the mercy of government hand-outs. Honestly, I can't see any downside, but huge benefits, to low, constant levels of price deflation. Can anyone else?

  Published: December 26, 2006 11:50 AM

• Dan Coleman

  Roger M,

  
  To be sure, I'd say that the bureaucrats stand to lose quite a bit!

  Published: December 26, 2006 12:00 PM

• RogerM

  Dan:"To be sure, I'd say that the bureaucrats stand to lose quite a bit!"

  Exactly! And another benefit of price deflation!
  

  Published: December 26, 2006 12:38 PM

• Sam

  So it's lending that causes business cycles not necessarily currency. But I do remember reading a short book about economics that issued two views which I would like to share:

  1. We not going back to the gold standard mainly due to there not being enough gold to satify the huge economies nowadays.

  2. Businesses expanding on equity rather than debt will slow the economy right down as few companies have that sort of savings for quick self-expansion.

  Perhaps interesting is the fun of investig, namly, risk and reward. Doesn't taking away the risk factor by stopping lending also take away the reward component?

  But anyway, a personal problem with deflation, as with inflation, is that overall real incomes stays the same overall anyway. It is said that when inflation is very, saving is still good as the depreciation factor for money is not enough to justify stupid spending. But it seems poor people can't seem to save for long-term, because somethings always seems to go wrong and they have draw on their savings. Hence short-term saving wouldn't suffer hardly under inflation but alternatively not gain much either with deflation. Surpise, surprise, the rich on the other hand would be in a much better position to save and therefore would have much to gain from stockpiling gold bars in a vault for currency apreciation. Perhaps doubly so if there wasn't any lending allowed.

  But as I've mentioned I don't see the point in Fudiciary money, wouldn't be safer to trade directly in gold instead? You wouldn't want to holding a paper note, going to the bank to get the gold, only to find it's long gone?

  Published: December 26, 2006 7:26 PM

• Mark Brabson

  Sam:

  Lending, per se, is not the cause of the business cycle. Rather, it is the runaway availability of credit made possible by fiat money and central banking. Central banking is the biggest culprit, since the fiat money issues allow astronomical credit to be made available.

  With commodity money and 100% reserve banking, lending will still be quite possible. In fact, the economy could not function without lending. The lending in this type of economy would be far more limited. It would be limited by the amount of money that people save in the form of timed deposits at banks. Timed deposits would become much more popular at banks, due to the enhanced value of saved money. This would set the amount of money available for lending. The interest rate would float at a market determined rate.

  If you are holding a bank note in a 100% reserve banking system, that note is pretty safe. There is no possibility of a bank run, and you can always self insure against bank robbery.

  Published: December 26, 2006 7:39 PM

• billwald

  The USofA in the last 40 years has seen price deflation (work hours required to buy something) in most every area except energy, housing, and medical costs.

  Published: December 26, 2006 7:44 PM

• rtr

  Fiat money is coerced theft. It's no different than if I were to walk into someone's home and force them to take monopoly money for their possessions. It's easy to print as much monopoly money as one wants.

  I think fractional reserve banking is an impossibility in a free market economy. Resources are limited in the real world. Real resources and goods cannot be magically multiplied by creating fake money. All the alleged incentives regarding inflation must necessarily be completely bogus, because inflation does not in the least increase real world resources and goods.

  Thus, who would trade food, shoes, and labor for pieces of monopoly money in a free market if they weren't forced to by government violence? Even in a free market, monopoly money banks could issue paper monopoly money, but who would trade real goods for that paper?

  You have to keep in mind "borrowing money" to purchase goods and resources today in return for paying back more goods and resources tomorrow, means somebody who owns real goods and resources must "voluntarily" trade those real goods and services. The "money" is just an intermediary step. Somebody who owns real goods and resources must trade those actual real goods and services voluntarily to another, in return for a promise of future payment.

  Fractional reserve banking, to the extent it exists, is fraud. Someone claims something backs the certificate which does not back the certificate, whether it's precious metals, or anything.

  The terms used over-complicate and obscure the economic analysis. Why call me pointing a knife at you and forcing you to take monopoly money for your coat "fiat money"? Why call you lending me your snow blower and swearing to you your snow blower is in my garage when I've in turn lent your snow blower to another neighbor "fractional reserve banking"? Stick to the actions, and follow the movement of the real goods and resources in real time. It's much simpler.

  It should be obvious that forcing paper money theft is a means of more easily dramatically increasing the size of the theft, the size of a theft needed for instance to pay for wars. Combine it with fraud. Then over a period of time, it's just as if you've dropped trillions and trillions of monopoly money dollar bills over cities. Except that the money wasn't dropped evenly and at the same time. A few people got it first, and it worked its way through the economy, inflated prices unevenly and non-simultaneously.

  One has to keep in mind that throughout history alleged examples of free market institutions may not necessarily have been so. Banks were chartered by governments. Banking rules were enforced by government. Gold and silver coins had pictures of government offcials imprinted upon them.

  Of course, fiat money and fractional reserve banking is a hot potato nobody wants to be holding when the music stops.

  People just want to trade labor and goods for other labor and goods. As labor becomes more productive and goods become more plentiful, it's obvious more goods can be traded for less labor. Money is just there as an intermediary lubricating of trading efficiency. Far too much attention and confusion has been paid to that money.

  Published: December 26, 2006 10:06 PM

• Sam

  Actually how would you insure yourself against a bank robbery?

  Anyway, in the gold-backed money society where lending would be difficult this then asks how does the bank lend? Paper money or gold? Who would qualify for this type of loan? What sort of collateral be required? What happens when the borrower can't pay? And besides, how much money/gold is needed for an economy? Surely you couldn't have one gold nugget with a super-duper buying capacity? What happens when more gold enters the system, inflation?

  Published: December 26, 2006 10:12 PM

• Sam

  What a grump you are rtr! I think we all know the less self-sufficient you and more reliant you are on someone else then that someone else has much power over you. Likewise it could be argued since few of us live on self-sufficient farms but rather live in cities engaging some repetitive specialised job, we have to more dependent on currency than a self-reliant farmer.

  Indeed to have your self-reliant farm, with the ability to get your own, or make, food, water, clothing, shelter, etc., combined with sufficient weaponry to repel invaders and tresspassers amounts to the greatest freedom possible . . .

  Published: December 26, 2006 10:27 PM

• rtr

  Why would lending be difficult in a gold backed society? If you want to borrow my snow blower what does money have to do with that? If I want interest for lending you my snow blower what does money have to do with you giving me my snow blower back along with an apple pie you baked?

  Only real goods and labor can be lent. Are you going to bake a pie with gold? Make shoes with gold? Bake a pie with dollar bills? Make shoes with dollar bills? Build a factory made out of gold or dollar bills?

  You could insure yourself against a bank robbery the exact same way you insure yourself against a flood.

  Published: December 26, 2006 10:27 PM

• Sam

  Well rtr, I mean as in the borrowing/lending in the modern economic sense, not living in a quaint lil farming village.

  Published: December 26, 2006 10:31 PM

• rtr

  Sam: "I think we all know the less self-sufficient you and more reliant you are on someone else then that someone else has much power over you."

  Except that it's not *one* single someone else, but hundreds, thousands, and millions competing against each other to give you better terms than someone else for trading business with you. You might be stranded in a socialist desert and along comes the czar on his camel to offer you a glass of water in return for 20 years of labor. Or you might be stranded in a free market desert and along comes 10 people offering you water, lemonade, martinis, grapes, etc. for a few metal pebbles or the equivalent of 15 minutes of labor. Which is better?

  Published: December 26, 2006 10:35 PM

• rtr

  Borrowing/lending is exactly the same in the modern sense as it is in the the quaint little farming village sense.

  Published: December 26, 2006 10:38 PM

• Sam

  Well I think it's a case of tough luck then. It seems that large societies by their nature are very interdepent which requires an overall currency which in turn must lead to their destruction.

  As I said before if folks want to have total freedom from coercion then they have to be self-sufficient and have weapons with which to repel any and every jerk who would steal their possessions.

  Published: December 26, 2006 10:44 PM

• rtr

  Well larger societies have greater division of labor which brings about greater wealth. They can hire better soldiers with better weapons for less to defend themselves. Freedom from coercion is what occurs all the time when free trade occurs. Freedom from coercion makes those who practice it wealthier. Destruction of society only occurs from the absense of free trade. That's why cities have large populations. London in the early 1800s was the first city to surpass 1 million people.

  Of course when you specialize in a particular labor you are dependent upon others for trade of all the other products of labor you don't produce yourself. Can you imagine how much poorer you would be if you had to grow your own food, make your own clothes, teach yourself education, etc.? You probably wouldn't have time for free economics lessons here at mises.org. :P

  Published: December 26, 2006 11:00 PM

• Sam

  But as I said when you are in an large interdependent society you personal freedoms are restricted as now you have to temper your freedoms against everyone one else's. The right to play loud music at all hours of the night is going to tick pretty much everyone else around you.

  But I do have ask though what would be the profit for the few to mass produce Fiat money and create ruinous inflation? To these few have all the gold bars that were swiped from masses, go to the airport for a trip to Brazil, saying "so long suckers! Ahahahahaa! Morons!"?

  Published: December 26, 2006 11:44 PM

• Sam

  To your last reply rtr:

  . . . Can you imagine how much poorer you would be if you had to grow your own food, make your own clothes, teach yourself education, etc.? . . .

  How about: imagine how much freer you were if you were self-sufficient and strong? Indeed even a large complex Libertarian society would require some sort of national defence which would require some sort of compulsory national service and some sort of compulsory attendence in times of invasion. Choosing not to fight would be a free-rider scenario thingy.

  But anyway I remember seeing a movie starring Jimmy Stewart as a bloke who owns a large family farm which is self-sufficient (or close enough so) whereby the Big Bad Government Army Conscriptors roll in and try to conscript his sons. Jimmy's character tell them that his sons are free to volunteer if they think the cause is right but he refuses to let them be taken against their will. And one can only presume that because the farm is self-sufficient and sufficiently armed that Jimmy's character can tell the Army conscriptors to piss off without any fear of retaliation.

  Published: December 27, 2006 12:14 AM

• George Gaskell

  The right to play loud music at all hours of the night is going to tick pretty much everyone else around you.

  Playing loud music is a property rights violation. It has nothing to to with the division of labor or economic interdependence (now that's a redundancy if there ever was one).

  Choosing not to fight would be a free-rider scenario thingy.

  Please tell me how you know that the so-called free-rider problem is so big that it justifies the creation of a massive organization that compels compliance. I hear about it all the time. (As far as I can tell, governments are the biggest free-riders of them all.)

  How you can calculate whether the claimed benefits of a nation state are outweighed by the costs. Because using government to solve this supposed free-rider problem sounds, at best, like using a nuclear bomb to kill a mouse.

  Why not let people decide on their own, like Mr. Stewart suggests? If the threat is real, rational, intelligent people will take action to remedy it. If the threat is real, but people are not smart enough to address it, then they get what they deserve, like failing to prepare for the winter or something. If the threat is not real, then conscripting people to fight a pointless contest seems particularly uncivil.

  Published: December 27, 2006 9:00 AM

• Dan Coleman

  Sam,

  How about: imagine how much freer you were if you were self-sufficient and strong?

  No one would prevent anyone from being "self-sufficient and strong" in a libertarian society. If you have a farm out in the country, and wish to refrain from trade for fear of developing dependence, all the more power to you as you seek fulfillment in life.

  All the libertarian asks is to be left alone in trying to achieve happiness in his or her own way. Only in a free (freedom as in liberty) society is this possible without molestation.

  
  After follows this chain of logic:

  Indeed even a large complex Libertarian society would require some sort of national defence

  Perhaps, but perhaps not. Switzerland has lasted for centuries on the basis that they would be tremendously difficult to conquer for reasons *other* than a centralized army. (They are relatively inaccessible, most citizens own firearms and would make occupation a living hell for the aggressors).

  The United States happens to be in a great position should it become a free society. Not only would it cease to be considered one political unit (thereby rendering your problem obselete), but it is entirely unlikely that other countries would seek to conquer us. Consider Canada -- who (besides the U.S.) has ever really waged war on them?

  At any rate, I was following the chain of thought. I reject your first statement:

  which would require some sort of compulsory national service

  Not only is this concern irrelevant once we dismiss your starting point, but this claim is clearly false.

  
  and some sort of compulsory attendence in times of invasion.

  Not only is this concern irrelevant once we dismiss your starting point, but this claim is clearly false.

  Choosing not to fight would be a free-rider scenario thingy.

  The "free-rider problem" is the child of commons -- that is, it is the 'tragedy of the commons' that creates the 'free-rider problem.' (See: http://en.wikipedia.org/wiki/Tragedy_of_the_commons )

  In a libertarian society there are no commons, and therefore there is no 'tragedy of the commons.' Therefore, there is no "problem" when it comes to free-riding. Not only would most people voluntarily defend their own property when it was under attack (as history has clearly shown to be the preferred action of peoples), but the wide array of defense services provided by the market would cover most (if not all) crises of invasion.

  At the very least, it would perform these services much more effectively, efficiently, and peacefully than the State does currently.

  Published: December 27, 2006 9:05 AM

• RogerM

  Sam:"1. We not going back to the gold standard mainly due to there not being enough gold to satify the huge economies nowadays.

  2. Businesses expanding on equity rather than debt will slow the economy right down as few companies have that sort of savings for quick self-expansion.

  Mises and others have demonstrated that the amount of gold doesn't matter. Almost any amount will do. As for #2, that's simply not true. A large part of business expansion is paid for by retained earnings. Besides, "expanding on equity" includes selling shares of stock to investors, so businesses don't have to rely solely on retained earnings.

  "Anyway, in the gold-backed money society where lending would be difficult this then asks how does the bank lend?"

  The same way banks lend today. Businesses would borrow money to finance projects where the profit is equal to or greater than the cost of financing it.

  "Paper money or gold?"

  Neither. Most money today is in the form of electronic digits, very similar to the accounting entries of the bankers in the middle ages.

  "Who would qualify for this type of loan? What sort of collateral be required? What happens when the borrower can't pay?"

  Nothing would change in this respect from the way things operate today.

  "And besides, how much money/gold is needed for an economy?"

  The amount of gold doesn't matter. If the economy today uses $200 trillion, then divide the amount of gold we have by $200 trillion to determine the ounces of gold each dollar is worth. It's that simple. The real problem in moving to gold as money is the huge amount of debt that the government, businesses and individuals have, because the resulting deflation would make it more difficult to pay off those loans.

  "Surely you couldn't have one gold nugget with a super-duper buying capacity?" Sure, why not?

  "What happens when more gold enters the system, inflation?" Exactly.

  You can sort out a lot of these issues if you first think about the way a barter economy works. An economy with gold money works the same way; money just greases the system so that goods can change hands faster.

  Published: December 27, 2006 9:24 AM

• Sam

  OOPS. Well I suppose I did put my foot in it before about the national defence bit. After all, it's the undeveloped nations that are more likely to have more idle natural resources and be poorly armed than complex ones.

  I was just supposing that an organised defense system meant everyone was expected to be a soldier in waiting. Hence I WAS thinking along the Switzerland lines inasmuch everyone would own a firearm of sorts. I was just thinking that everyone in a proverbial Libertarian would need training in militia tactics, weapon handling and maintenance, bush survival skills, etc. As the part of compulsory attendance I meant that people would immediaetly drop everything, grab their arms and group together to outnumber an invading army. And finally (about the free-riding bit) how would a militia be effective if half the 'army' were too scared to meet the enemy or have many individuals presuming "well there's probably militia folk fighting the invaders already so I'll stay here since there point in me getting my head shot off".

  I was just concerned about if a Libertarian society could become too loosely connected that invaders could easily run roughshod thanks to the ol 'divide and conquer' strategy.

  Published: December 27, 2006 9:28 AM

• Sam

  Heck, Roger M, with regard to gold-backed paper money (I believe it's called Fudiciary money) I do believe economic slumps occurred in those times because bankers ignored the paper money to gold ratio and printed more paper money willy-nilly. They did this on the basis that few people actually brought the money back in for the actual gold. Indeed, bankers who were supposed have a strict 100% ratio between paper money and gold, couldn't help but think "Gee look at all this idle gold maybe we could issue more money and create more profits. Since almost no one comes in asking for gold, no one will be the wiser". For some strange reason I would think that when the 100% ratio was broken, Fudiciary money would become more like Fiat money. That is, you had paper money that couldn't be traded in for gold. And that was the whole cause of bank run, wasn't it? Once people got wise to the fact there's more money than gold, people would start trading in the money for gold and oops the bank can't cater everyone, it goes bankrupt and one would presume people used strict gold currency until they could be convinced to start using Fudiciary money all over again.

  But I would think that since paper money could be manipulated to create in a way that has already been described as inflation or easy credit then the only safe conclusion is to use gold weights directly. Screw paper money before it screw us, no?

  Published: December 27, 2006 9:54 AM

• George Gaskell

  And that was the whole cause of bank run, wasn't it? Once people got wise to the fact there's more money than gold, people would start trading in the money for gold and oops the bank can't cater everyone, it goes bankrupt and one would presume people used strict gold currency until they could be convinced to start using Fudiciary money all over again.

  Yes, it was.

  And this sort of problem got even worse when government thugs (but I repeat myself) got the bright idea to "fix" things by passing "laws" whereby, in times of this sort of crisis (necessary, inevitable, and cleansing though it may be for the economy as a whole), banks could "suspend specie payment" to keep from going bankrupt.

  "Suspend specie payment" is government-speak for granting banks the special privilege of defaulting on their obligation to give real money in exchange for a claim ticket (i.e., a paper bill).

  The problem, as they saw it, wasn't the massive fraud of fractional reserve banking, but those irritating customers who insisted on claiming what was rightfully theirs. So, hey, screw the customers, and it's problem solved.

  Published: December 27, 2006 4:44 PM

• Mike Sproul

  George
  What if the government wasn't involved in banking? What if a bank offered to take deposits, lend out 90% of the deposits at interest, and pay interest to depositors. AND what if the depositors agreed to it? Then any good libertarian should be OK with it. Furthermore, if it were outlawed in one country, and legal in a foreign country, would you pass laws against using the foreign money?

  Published: December 27, 2006 7:31 PM

• Sam

  To Mike Sproul & others:

  Isn't the mismanagement of paper money proof that if you stop such mismanagement then the only way is one of full gold as currency?

  Published: December 27, 2006 7:49 PM

• Mike Sproul

  Sam:
  Bank A holds 100 ounces of silver as backing for 100 paper dollars. Bank B holds 25 ounces of silver, plus IOU's worth 75 ounces of silver, as backing for 100 paper dollars. If bank B is mismanaged and loses some of its IOU's or some of its silver, then its paper dollars will lose value. If bank A is mismanaged and loses some of its silver, then its dollars will lose value. The problem is not fractional reserves. The problem is the mismanagement. The form in which a bank holds its assets is irrelevant.
  

  Published: December 27, 2006 8:56 PM

• Sam

  To Mike Sproul:

  That's what my last entry indeed said, I differed inasmuch as paper money can be manipulated a lot easier than gold. Hence a direct gold currency is less prone to mismanagement per se.

  Published: December 27, 2006 9:00 PM

• averros

  No, Mike, the problem with fractional reserve is not mismanagement, the problem is that it is fraudulent.

  If banks doing fractional reserve made clear that what they issue is not risk-free and redeemable at any time depositary receipts but rather risky IOUs, there would be no problem.

  As is, the banks pretend that these IOUs are money. They are not - there's still a real risk that the depositors will lose their deposits (something which can never happen with real money, in the absense of theft or natural catastrophe).

  In fact, it is guaranteed that under the system of fractional banking some of the depositors WILL lose their deposits. Any system of fiat money eventually collapses in a hyperinflation death spiral.

  Published: December 27, 2006 9:06 PM

• rtr

  "What if a bank offered to take deposits, lend out 90% of the deposits at interest, and pay interest to depositors."

  Why would the depositors use the bank as a middleman? Instead of putting their money in the bank they could just directly buy stock in a company, buy mortgage bonds to finance a property aquisition, etc. You can't at the same time have money lent out by the bank and returned to the original depositors. The bank is scalping the interest that could be paid to the depositors if the depositors themselves had lent out that money for those particular uses the bank does, while simultaneously imposing those risks of default on those depositors. If the money deposited can be withdrawn at any time, then having lent out that money and not being able to return that money back to the depositor at any time is fraud. But the bank pretends its received IOUs from other borrowers are your money. When the bank lends you money to purchase a house are you allowed to bet that money at the track instead?

  Published: December 27, 2006 11:03 PM

• Mark Brabson

  I should point out that depositors always have the option of making timed deposits, as opposed to demand deposits. A six month Certificate of Deposit being an example of a timed deposit. Banks are free to use money from timed deposits to lend out. If banks wish to lend, then encourage timed deposits.

  Demand deposits are just that. They are payable on demand. You can't lend out money that may be subject to a redemption demand on the morrow.

  Published: December 27, 2006 11:14 PM

• Ozzie

  "But what of depreciation? The first to buy risks watching their thingo price plummet. Indeeed the resale of computer parts tends to be pathetic with time, meaning that most would hold off buying or upgrading a computer until necessary. Goodness knows I do."

  Magnificent if you are right. Because what you are really talking about is a higher savings rate. Which means the end of poverty if universally applied along with other aspects of economic freedom.

  What is the problem here?

  But in fact on a 100% backed precious metals standard the volume of spending would wind up expanding all the time. Since the volume of monetary metals would always grow slowly yet never reduce.

  What wouldn't happen is the constantly oscillating and unstable money supply and velocity that you get when you throw fractional reserve into the system.

  Published: December 28, 2006 2:06 AM

• Sam

  A question of interest: is there any other currency replacement for gold?

  If not, does this means any experiments to make gold transmutation cost-effective should be illegal? Or if a discovery of a seemingly endless vein mean that it should never be mined lest gold becomes a common metal?

  Published: December 28, 2006 4:05 AM

• adi

  Sam, there has been many commodities which have been used as a money (cocoa beans, sea shells, squirrel furs, silver, rice, cigars in POW camps etc) depending on local history and natural resources. Gold is not more natural than any other commodity so only time will tell which is adopted by some group of interacting people. Europeans used silver many centuries even when most people lived in autarchy and didnt see coins in all their lives.

  Suppose that at one point of time gold is solely used as money and then someone invents method to produce this numeraire in unlimited quantities. Then we can be sure that some other commodity is taken in use as a money.

  Published: December 28, 2006 6:06 AM

• banker

  Don't forget that prices are just fractions! This means that the quantity of money is irrelevant, only that the increase in the money supply is bad.

  (10 hrs of office work)/($1,000) * ($140,000)/(1 house)

  Notice that both quantity and price are used in calculating the relative worth of different items. Price without quantity means absolutely NOTHING! So there is no need to worry about declining prices for products because that is associated with a corresponding increase in the quantity of goods. Supply and Demand.

  
  As for fractional reserve banking, there is nothing wrong with depositing your money at a fractional reserve bank so long as both parties realize what is being transacted. However, it has to clearly state the situation in contract terms (mainly that the depositor is not guaranteed his/her deposit back).

  For clarification, an IOU is not the same as a receipt. One is a loan, while the other is a custodianship.

  
  PS Answer for previous post is that so long as currency choice is purely private and voluntary, it does not matter.
  

  Published: December 28, 2006 6:13 AM

• George Gaskell

  What if a bank offered to take deposits, lend out 90% of the deposits at interest, and pay interest to depositors.

  Then the "depositors" aren't really depositors. They are lenders, loaning money to a business that promises to repay the loans with interest.

  Which is all fine and good, except that banks are granted special exemption from the ordinary disclosure requirements of borrowers.

  If banks were subject to the same rules of disclosure and due diligence that apply to every other form of commercial misrepresentation, then I'd have no problem.

  Published: December 28, 2006 9:38 AM

• Mike Sproul

  George, banker, adi, sam, ozzie, rtr, averros:

  A quick opinion poll: Do you agree or disagree that fractional reserve banking should be legal IF both the banker and the depositors (call them lenders if you want) agree to it? George, banker, and averros appear to have already said they agree. How about the rest of you? I ask because Rothbard, among others, said it is fraudulent, and that the customers don't know what they are agreeing too. To me this seems like the glaring flaw in austrian economics--to be so right about the workings of free markets and so wrong about fractional reserve banking and money.

  Published: December 28, 2006 11:26 AM

• Dennis Sperduto

  Whether or not a specific act or process is fraudulent, is a legal, and not an economic issue.

  From an economic standpoint, I would argue (and other Austrians have argued) that in a true free market monetary system, if fractional reserve banking was agreed to by certain participants, the notes issued by the fractional reserve bank would trade at a discount to face value because at least some market participants would realize that the risk of default would be greater for a fractional reserve bank than for a 100% reserve bank. Once a money substitute trades at a discount to face value, its use as money has been compromised.
  

  Published: December 28, 2006 12:06 PM

• David White

  Mike Sproul:

  I'm with Dennis in saying that in a free market, fractional reserve banking would not be inherently fraudulent, merely risky vis-a-vis 100% reserve banking, and that as long as consumers were able to choose freely between the two (and knowledgeably so, due to outside auditing), all would be fine.

  That is, I might be willing to deposit my money (gold, silver, or whatever else the bank would accept) with the understanding that a fractional reserve bank would pay me interest for doing so, while a 100% reserve bank would charge me a storage fee, mindful that the more risk I took in this regard, the less likely others would be to accept the money substitutes issued by the bank in question.

  "Oh, you're banking with Frac-O-Serv; I'll need to add a surcharge of 10% to cover the added risk of your banknotes." And conversely, "Oh, you bank with Solid Gold and therefore qualify for a 5% discount on all purchases."

  The larger point, however, is that the present system IS fraudulent for the simple reason that it operates via government edict and thus outside the confines of the free market, forcing people to use its money whether they want to or not. Moreover, because its money is but paper with nothing backing it up, people are forced to use that which isn't money at all but the corruption thereof. After all, who would be foolish enough to accept such fluff in a free market?

  "I'm sorry, but we don't do business with people who bank with Paper Pushers. Next!"

  Published: December 28, 2006 12:30 PM

• Mark Brabson

  Mike Sproul:

  I would be opposed. That said.

  If depositors agreed to make a deposit that may not necessarily be available on demand, then the deposit should rightly be called a timed deposit and recorded in ledger form at the bank. There should be no banknotes issued against such deposits, but all such deposits should be recorded in ledger form only. Any banknotes issued against non-demand deposits must necessarily depreciate and as an Austrian I simply can't tolerate depreciating paper money.

  Any banknotes in circulation must be against 100% reserve demand deposits only. By the way, it is quite possible for the same bank to maintain 100% demand deposits and engage in timed deposit banking at the same time. Just as long as an absolute firewall is maintained between the two separate ventures.

  Published: December 28, 2006 1:07 PM

• greg

  MS> The confusion is being caused by the quantity theory of money, which is wrong, as opposed to the real bills doctrine, which is right.
  

  "Real Bills" is not correct. Government fiat money is not backed in the plain sense of "backing." Government money is, at best, backed by seizure of assets. That is, the assets of others. But that isn't the same thing as "backing" when it comes to any private dealer of money and assets, is it Mike? Moreover, there is no law I am aware of that can strictly prevent a complete monetization of debt. Of course, that may be a practical stretch because of the threat of serious political consequences. But serious political consequences aren't the same thing as backing, are they Mike? In practice, the political consequences are the only remaining governor on government money.
  

  MS> What if a bank offered to take deposits, lend out 90% of the deposits at interest, and pay interest to depositors. AND what if the depositors agreed to it?
  

  Those aren't really deposits. They are investments.
  

  MS> Then any good libertarian should be OK with it.
  

  Well of course they'd be okay with investment; just call it what it is.
  

  If you make-over the words backing and deposit enough, you'll get the answers you want. I do not find your re-definitions (and then conclusions) persuasive.
  

  Published: December 28, 2006 4:53 PM

• Mike Sproul

  Four of you (george, banker, averros, dennis, and greg) more-or-less agreed that fractional reserve banking is OK as long as both parties agreed to it. One disagreed (mark), and 4 didn't comment (adi, sam, ozzie, and rtr). That's a fairly surprising majority for an austrian blog, given the longstanding austrian claim that fractional reserve banking is inherently fraudulent.

  The real bills position is that fractional reserves is not fraudulent, nor is it inflationary. Bank A can issue 100 green paper dollars backed by 10 oz. of silver plus IOU's worth 90 paper dollars. Bank B can then issue 200 checking account dollars backed by 20 green paper dollars plus IOU's worth 180 checking account dollars. As long as bank assets hold their value, so that every dollar is adequately backed, either or both of these banks can issue dollars without causing inflation.

  Somehow I doubt I'll get a majority of you favoring the real bills view, but for the rare individual who wants to check it out, go to

  www.geocities.com/sproulmike/nofiatmoney.doc

  or google "sproul fiat money".

  Published: December 28, 2006 8:13 PM

• averros

  Mike - it is immaterial to ask what would be if banks disclosed what they do. Simply because they don't do it. They are fraudsters, period.

  And, no, I do not think anyone in his right mind would voluntary use unsecured and uncontrollably issued IOUs instead of money. But I also see no reason to prohibit good-faith issue of such instruments - provided that I can get my real gold money, too.

  Published: December 28, 2006 10:13 PM

• Sam

  I read your article M. Sproul but I'm still confused in areas. In your example of the $100 silver-backed dollars, versus the $200 loaned to the farmer, are the $300 the same type of dollars? Could the farmer cash in $100 for silver leaving the bank with nothing but $200 debt?

  Why should people entrust a bank or government to hold the precious metals, get paper money in return and think it is better? The centralised nature of a bank or government means one large-scale robbery of the precious metals would throw the nation into financial chaos.

  Why can't someone roll into to town, tell a ripping yarn of a central store of precious metals in return for paper money and when the townsfolk agree, takes the precous metals, hand out the pretty coloured paper, shoot through and people wake up realising they have just been swindled?

  Why can't people trade directly in gold and silver anyway? Why have banks at all?

  -------

  Actually M. White is there any laws against bartering? I heard that when Microsoft bought out HotMail it used its own shares not U.S. cash. Similarly if enough people despise the U.S. currency why couldn't they start using Euros?

  -------

  Finally, before my question of 'is there any substitute for gold?', I was asking for a real-world working alternative. I mean if gold was deemed worthless tomorrow could there be a real world alternative? Platinum? Silver?

  Published: December 28, 2006 10:49 PM

• Mike Sproul

  Sam:
  In the example all of the $300 are of the same type.
  If the farmer tried to cash $100 for 100 oz., that would be inconvenient for the banker, but the banker could head-off this demand by selling $100 of his IOU's for his own paper dollars and then retiring the dollars, thus soaking up the unwanted dollars. Then the farmer will find that he can easily sell his dollars for silver on the open market. There are other ways: For example, the farmer could give the bank a few hours notice that he wants silver. The bank could sell $100 of IOU's for silver, and then redeem $100 for silver for the farmer without disrupting banking operations.
  People have often preferred paper money to metals. Paper is easier to carry for one thing, and surprisingly, coins are easier to counterfeit than paper.
  Of course people can get conned by bad bankers, but they still benefit from honest bankers.

  Published: December 29, 2006 12:06 AM

• adi

  Mike, FR banking is not necessarily fraudulent if the customers know what they are doing. Existence of government money and central bank hides something important though: money could as well be private matter between market participants and not any govt created fiction.

  Dollars are no backed by anything since government can increase money supply by unlimited quantities. There is no limit for governments debt if central bank is forced to purchase govts papers and return interest payments back to govt (situation is same like saying that I have now less money since I put Euros from my left pocket to the right pocket).

  Merchants have always used commercial papers as a clearing device when it has been inconvenient to transfer large amounts of gold between locations. Medieval fairs are example of this kind of activity. But I would doubt that ordinary people would accept these papers as a money (of course in those days use of money was limited in the autarchic economy).

  Mike, why would people hold money at all in your theory if the IOU's are perfect substitutes for money for the banks (so that they are willing to hold these in their portfolios instead of holding commodity money)? Why people dont use these papers directly? We could as well assume away all costs about holding these papers and using them if you have assumed away all risks associated with the possibility of not having back the amount of deposited money.

  Sam, in medieval times banks used to provide services for their customers. They didnt always loaned money away because they just provided accounts and storage facilities. Following example: suppose that merchant is travelling to Germany from Italy to purchase North European stuff and sell exotic material there. Merchant has account in Venetian bank which has branch office in Frankfurt am Main. Merchant can deposit gold in Venice and withdraw it in Frankfurt or give sellers there right to transfer money from his account to theirs. So in short banks provide economic services as any other agency (like real estate agent).

  Published: December 29, 2006 4:59 AM

• Ozzie

  "George, banker, adi, sam, ozzie, rtr, averros:
  A quick opinion poll: Do you agree or disagree that fractional reserve banking should be legal IF both the banker and the depositors (call them lenders if you want) agree to it? "

  Well its OZZIE speaking here and thats a complicated question though it might not seem to be.

  Something very strange happens when we get to this subject.

  The ANARCHO-CAPITALIST-PURIST hat comes on.

  Now I don't know. Perhaps all good men and true are anarcho-capitalist-purists when they contemplate the longer run at Christmas time.

  But why put that hat on when it comes to this subject?

  Every one of our great Austrian economists has a different way of dealing with this question.

  But here I think I'll channel young Dr Hulsmann. Who may one day become our greatest living economist but he's just too young yet.

  Traditionally fractional reserve always starts with fraud and embezzlement as Dr Salerno pointed out in a recent recording.

  Its not fraud now because its socialism (or if you must "interventionism")

  But at least in those years that 100% backed metals involve falling consumer prices and low nominal interest rates AN HONEST VERSION OF FRACTIONAL RESERVE has no rationale.

  It cannot really work provided there is what might more normally be thought of as an excess of vigilance preventing this type of fraud in its dishonest form to prevail.

  Hullsman identifies the honest form of this financial product as an IOU+RP contract.

  That is to say an "I owe You" plus a "Redemption Promise"

  In a situation of great vigilance this financial product would be like a different type of money trading at a discount or alternatively a financial product negotiated by specialist traders.

  But off my own bat I would add that the market may well pick up this product and run with it under 2 situations.

  1. A situation of abnormally high nominal interest rates... (like what might be produced by war financing)

  and

  2. The upshot from a freak find of massive monetary-metal deposits.

  Now I would say under these two cases the honest-fractional-reserve product could make headway.

  And the vigilance against the dishonest form could be relaxed.

  But taking no. 2 and thinking about the monetary implications of it.....

  .....Wouldn't that just be the worst of all possible times to allow fractional reserve?

  Look we need to find a way of getting to it that natural law can be enforced locally and privately.

  Or at least thats what an anarcho-capitalist might think.

  But in transition there are some restrictions that ought to be slated to be gotten rid of towards the end of the liberation process and not at the beginning.

  For the next three decades might we not accept that fractional reserve is on the out?

  Simply because with it there we cannot showcase a monetary system that is better then the socialists ones both in theory and in practice.

  And also because we want a new and reformed and vastly more powerful system for reinvesting savings.

  And we ought not want to have to wait until pure liberation is acheived.

  I think in a better world the doubters will very easily understand that fractional reserve under libertarian conditions is fraud.

  And not only fraud but a special sort of fraud that we need to be more then normally vigilante about.

  But if I'm wrong about that why not let the proscription against fractional reserve go down the tubes with the last thousand pages of regulations before pure minarchism or pure anarcho-capitalism is acheived?

  We cannot showcase a new and superior way of running our financial system under conditions of near-pure-liberty if we don't at first phase out fractional reserve.

  Even as a tactical matter it makes sense to do this.

  Published: December 29, 2006 6:37 AM

• Björn Lundahl

  100 percent gold reserve money standard
  
  I quote from America’s Great Depression, by Murray Rothbard:

  Preventing Depressions

  “Private banks, it is true, can themselves inflate the money supply by issuing more claims to standard money (whether gold or government paper) than they could possibly redeem. A bank deposit is equivalent to a warehouse receipt for cash, a receipt which the bank pledges to redeem at any time the customer wishes to take his money out of the bank's vaults. The whole system of "fractional-reserve banking" involves the issuance of receipts which cannot possibly be redeemed”.

  And:

  “But a 100 percent gold reserve requirement would not be just another administrative control by government; it would be part and parcel of the general libertarian legal prohibition against fraud. Everyone except absolute pacifists concedes that violence against person and property should be outlawed, and that agencies, operating under this general law, should defend person and property against attack. Libertarians, advocates of laissez-faire, believe that "governments" should confine themselves to being defense agencies only. Fraud is equivalent to theft, for fraud is committed when one part of an exchange contract is deliberately not fulfilled after the other's property has been taken. Banks that issue receipts to non-existent gold are really committing fraud, because it is then impossible for all property owners (of claims to gold) to claim their rightful property. Therefore, prohibition of such practices would not be an act of government intervention in the free market; it would be part of the general legal defense of property against attack which a free market requires.[28], [29] .”

  http://mises.org/rothbard/agd/chapter1.asp#preventing_depressions

  As Walter Block puts it:

  “At present, money placed in a bank is called a "demand" deposit, logically implying that it would be available, in full, whenever demanded, with a probability of certainty. If the "fractional reserve parking lot" were to be an accurate analogy to monetary practice, instead of being called a "demand" deposit, it should be called "purchasing a lottery ticket for money," or some such. Further, in every other way-publicity, explicit contracts, etc.-banking procedures would have to be brought into line with parking lot practice. Then, and only then, could the charge of fraud be dropped. Under such conditions, there would still be the empirical question of whether or not anyone would purchase a "lottery ticket money deposit."

  http://mises.org/journals/rae/pdf/rae9_1_3.pdf

  
  With a 100 percent gold reserve money standard it is not possible for the Federal Reserve just to print money. If the Federal Reserve would be allowed to exist under that standard (for what purpose?), it has to have acquired the gold first before it could issue gold notes of that certain amount of gold*. Those gold notes would be receipts (gold claims) and the Federal Reserve has to store the gold until the owners of those gold notes claims the gold. The total money supply has not increased as the gold stored at the Federal Reserve is not an effective part of it and is therefore not counted as money. The total money supply has not either decreased, as mentioned gold notes, which are used as money, have replaced the gold as an effective part of the money supply.

  
  • In other words, the Federal Reserve has to be productive through enterprise or work to acquire the gold. How that would be possible, I really do not know. Another possibility for the Federal Reserve to acquire the gold is that someone donated the gold to the Federal Reserve.

  Björn Lundahl
  Göteborg, Sweden

  
  

  Published: December 29, 2006 7:11 AM

• Mike Sproul

  I suppose you'll soon be tired of my opinion polls, but here's another:

  Suppose a bank issues $1000 (either the paper kind or the checking account kind) and receives in exchange 100 oz. of silver, plus IOU's worth $900, which it keeps in its vault. The bank announces in advance that its dollars will be redeemable for 1 ounce AFTER 24 years, but will be inconvertible until then. The bank earns interest on its assets, but that interest is just sufficient to pay the cost of maintaining the $1000 in circulation (e.g., printing, chasing counterfeiters, etc.). The bank also promises, credibly, that it will at all times maintain the market value of the dollar at 1 ounce. If the dollar starts to trade for less than 1 ounce the bank will sell IOU's and soak up dollars, while if the dollar rises above 1 ounce the bank will buy bonds and emit new dollars.

  Would you austrians call that fraud? Or is it OK, as long as the bank and its customers agree to it?
  (Note: one reason I ask is that I have just described how the fed operates, and I hope I've given you reason to doubt that the dollar is fiat money--that it is actually backed but inconvertible.)

  Published: December 29, 2006 11:35 AM

• greg

  The bank announces in advance that its dollars will be redeemable for 1 ounce AFTER 24 years, but will be inconvertible until then.
  

  [O]ne reason I ask is that I have just described how the fed operates, and I hope I've given you reason to doubt that the dollar is fiat money--that it is actually backed but inconvertible.
  

  It is not how the Fed/Guv operates. The Fed/Guv does not redeem a dollar for an ounce, or any other non-dollar asset of its own. It redeems iou's (in dollars) for dollars, and inflated ones at that. The guvmint has no dollar backing except, at best, asset seizure by force (or the very real threat of force), and the real threat of monetization of debt to its creditors. But that isn't same backing as is meant when you and I have to back a debt, is it Mike?
  

  How about you lend me $100? I'll back it (pay it back) by promising I'll get that $100+Interest back to you somehow, either by printing money that looks like the same money we and our neighbors already hold, or by robbing assets from unspecifed neighbors of mine, one of which is you. How is that for a deal? How will the neighbors like me diluting the value of money on a deal they were not a party to (not to mentioned how they enjoy getting robbed to cover the costs of my printing and asset seizure operation)?

  Published: December 29, 2006 4:36 PM

• Björn Lundahl

  I quote from the book For a New Liberty, by Murray Rothbard:

  9 Inflation and the Business Cycle: The Collapse of the Keynesian Paradigm

  ”By far the most important route for the Fed's determining of total reserves is little known or understood by the public: the method of "open market purchases." What this simply means is that the Federal Reserve Bank goes out into the open market and buys an asset. Strictly, it doesn't matter what kind of an asset the Fed buys. It could, for example, be a pocket calculator for twenty dollars. Suppose that the Fed buys a pocket calculator from XYZ Electronics for twenty dollars. The Fed acquires a calculator; but the important point for our purposes is that XYZ Electronics acquires a check for twenty dollars from the Federal Reserve Bank. Now, the Fed is not open to checking accounts from private citizens, only from banks and the federal government itself. XYZ Electronics, therefore, can only do one thing with its twenty-dollar check: deposit it at its own bank, say the Acme Bank. At this point, another transaction takes place: XYZ gets an increase of twenty dollars in its checking account, in its "demand deposits." In return, Acme Bank gets a check, made over to itself, from the Federal Reserve Bank.

  Now, the first thing that has happened is that XYZ's money stock has gone up by twenty dollars—its newly increased account at the Acme Bank—and nobody else's money stock has changed at all. So, at the end of this initial phase—phase I—the money supply has increased by twenty dollars, the same amount as the Fed's purchase of an asset.

  "If one asks, where did the Fed get the twenty dollars to buy the calculator, then the answer is:
  it created the twenty dollars out of thin air by simply writing out a check upon itself. No one, neither the Fed nor anyone else, had the twenty dollars before it was created in the process of the Fed's expenditure".

  But this is not all. For now the Acme Bank, to its delight, finds it has a check on the Federal Reserve. It rushes to the Fed, deposits it, and acquires an increase of $20 in its reserves, that is, in its "demand deposits with the Fed." Now that the banking system has an increase in $20, it can and does expand credit, that is, create more demand deposits in the form of loans to business (or to consumers or government), until the total increase in checkbook money is $120*. At the end of phase II, then, we have an increase of $20 in bank reserves generated by Fed purchase of a calculator for that amount, an increase in $120 in bank demand deposits, and an increase of $100 in bank loans to business or others. The total money supply has increased by $120, of which $100 was created by the banks in the course of lending out checkbook money to business, and $20 was created by the Fed in the course of buying the calculator.

  In practice, of course, the Fed does not spend much of its time buying haphazard assets. Its purchases of assets are so huge in order to inflate the economy that it must settle on a regular, highly liquid asset. In practice, this means purchases of U.S. government bonds and other U.S. government securities. The U.S. government bond market is huge and highly liquid, and the Fed does not have to get into the political conflicts that would be involved in figuring out which private stocks or bonds to purchase. For the government, this process also has the happy consequence of helping to prop up the government security market, and keep up the price of government bonds”.

  “So here we have, at long last, the key to the mystery of the modern inflationary process. It is a process of continually expanding the money supply through continuing Fed purchases of government securities on the open market. Let the Fed wish to increase the money supply by $6 billion, and it will purchase government securities on the open market to a total of $1 billion (if the money multiplier of demand deposits/reserves is 6:1) and the goal will be speedily accomplished. In fact, week after week, even as these lines are being read, the Fed goes into the open market in New York and purchases whatever amount of govern¬ment bonds it has decided upon, and thereby helps decide upon the amount of monetary inflation.”

  * The reserve requirement set by the Federal Reserve on banks is exemplified by the ratio 6:1 (the required maximum multiple of deposit to reserves).

  http://mises.org/rothbard/newliberty9.asp

  Björn Lundahl
  Göteborg, Sweden

  Published: December 29, 2006 4:39 PM

• Björn Lundahl

  The purchasing power of money, the gold standard and fiat money

  
  I quote from the book “Democracy The God That Failed”, by Hans-Hermann Hoppe, page 58:

  “During the monarchical age with commodity money largely outside of government control, the “level” of prices had generally fallen and the purchasing power of money increased, except during times of war or new gold discoveries. Various prices indices for Britain, for instance, indicate that prices were substantially lower in 1760 than they had been hundred years earlier, and in 1860 they were lower than they had been in 1760. Connected by an international gold standard, the development in other countries was similar. In sharp contrast, during the democratic-republican age, with the world financial center shifted from Britain to the U.S. and the latter in the role of international monetary trend setter, a very different pattern emerged. Before World War I, the U.S. index of wholesale commodity prices had fallen from 125 shortly after the end of the War between the States, in 1868, to below 80 in 1914. It was then lower than it had been in 1800. In contrast, shortly after World War I, in 1921, the U.S. wholesale commodity price index stood at 113. After World War II, in 1948, it had risen to 185. In 1971 it was 255, by 1981 it reached 658 and in 1991 it was near 1,000. During only two decades of irredeemable fiat money, the consumer price index in the U.S. rose from 40 in 1971 to 136 in 1991, in the United Kingdom it climbed from 24 to 157, in France from 30 to 137, and in Germany from 56 to 116.

  Similarly, during more than seventy years, from 1845 until the end of World War I in 1918, the British money supply had increased about six-fold. In distinct contrast, during the seventy-three years from 1918 until 1991, the U.S. money supply increased more than sixty-four-fold.”

  Björn Lundahl
  Göteborg, Sweden

  
  

  Published: December 29, 2006 6:16 PM

• Sam

  All the discussion has shown that direct gold weights (and silver and platinum weight too i s'pose) should be the direct currency. If trading parties want to use temporary IOUs then good luck to them. But as it has been pointed out that more paper money can be printed will-nilly. Whilst theoretically gold can be transmuted it's probably never going to be cost-effective. Similarly most major gold deposits have probably been uncovered, it's possible but hard to believe there's a huge deposit just waiting to be found.

  Therefore direct gold weights are the answer to the robbery that is using mindless pieces of paper.

  Published: December 29, 2006 9:07 PM

• Peter

  Mike, FR banking is not necessarily fraudulent if the customers know what they are doing.

  But it's not just the customers that are concerned. If Adam, a customer of a FR bank, "deposits" 100oz of silver and gets 100 "dollar bills" in exchange, and the bank then lends out 90oz of the silver, when Adam tries to buy something from Bob with his "dollars", it's Bob who is being defrauded. Or if Bob figures out what's going on and chooses to accept the funny-money anyway, and then he goes and buys something from Carol with that money, Carol loses. It's not just a matter of "the customers know what they're doing"; everybody, throughout the entire economy, has to know and agree before there's even a hope of it not being fraudulent. (Though I'd argue that it's still criminal even then. A Ponzi scheme is crooked, no matter if everyone involved understands how it works - of course nobody would get into it if they know it's "topped" and they're going to be the losers, but if you get into a Ponzi thinking that you're in early enough that other people will lose, you're still counting on robbing those people)

  Published: December 29, 2006 9:30 PM

• Ozzie

  "The bank announces in advance that its dollars will be redeemable for 1 ounce AFTER 24 years, but will be inconvertible until then"

  Thats fine so long as they can pay it back.

  You see the thing is to clarify property rights and who has possession of the funds.

  The fraudulent side of fractional reserve is where the customer is supposed to have access to the funds. Yet the bank has lent those funds out.

  And thats not fraudulent now because there is all this cartelisation, regulation and government banking. And so the banks can reasonably fulfill their committments to their depositers.

  But under free enterprise conditions it would be fraudulent. And a very dangerous type of fraud that has a Greshams-law-like element to it. A kind of spreading-plague like element setting it apart from other forms of fraud.

  Clarifying property rights in this case means making absolutely clear whether the money is being warehoused to be available on call.

  Or being lent to be relent out to other clients and to be returned by a specific date.

  And if you clarify property rights in that way and are vigilant about it nothing much can go wrong once the system is well established.

  Now you can dream up an IOU + RP scenario that is not fraud under free enterprise conditions.

  But its probably less of a hassle just to phase fractional reserve out and then outlaw it. Because you cannot rely on people down the track understanding money good enough to be able to tolerate such practices and not let them get out of hand.

  Others who believe in 100% backing will disagree. But to me its really a protection reigning in the government like a constitutional limitation.

  Because once this is outlawed it rules out one of the subtle and clever ways that the government can gyp us all on the sly in league with the banking system.

  We want to rule that possibility out and not leave it to the government of the day to choose whether or not they can have fractional reserve.

  Published: December 30, 2006 7:10 AM

• George Gaskell

  But it's not just the customers that are concerned. If Adam, a customer of a FR bank, "deposits" 100oz of silver and gets 100 "dollar bills" in exchange, and the bank then lends out 90oz of the silver, when Adam tries to buy something from Bob with his "dollars", it's Bob who is being defrauded. Or if Bob figures out what's going on and chooses to accept the funny-money anyway, and then he goes and buys something from Carol with that money, Carol loses. It's not just a matter of "the customers know what they're doing"; everybody, throughout the entire economy, has to know and agree before there's even a hope of it not being fraudulent.

  That's an excellent point, Peter. It's along the lines of what I had in mind when I said that in order for the use of fractional reserve banking to be non-fraudulent, it would require extensive disclosure.

  In this case, it would require something along the lines of having the bill denominated with the minimum amount of genuine assets that back it.

  Paper currency would need to be marked with something like the phrase: "This bill may be backed with as little as 8% of its face value in gold." For the bank to deplete its reserves below that amount would be to perpetrate a fraud on everyone who accepts that note.

  Bills marked with higher percentages would trade at a smaller discount, of course. Fully backed gold certificates would trade at face value, or even at a premium, given the convenience factor.

  If you trade in stocks, the parties to the transaction are required to disclose the financial state of the corporation. They usually solve this problem by resorting to independent, publicly listed rating services. Without some form of reliable disclosure, the parties to the trade do not know the real value of the stock certificate. If the seller fails to disclose the real assets and liabilities that lie behind the stock certificate, he's a fraud.

  It's certainly possible for the parties to engage in a non-fraudulent transaction, even in junk bonds, provided there is full disclosure. People do so all the time. But knowing the financial condition of the bond's issuer is an essential part of knowing the risk of default and thus knowing the value of the bond.

  Same basic idea here. If a note of currency is really an IOU, and not a claim ticket for metal, as Mr. Sproul states, then the real value of the IOU is not its face value, but the financial viability of the debtor and its ability to pay. Bonds are rated by the risk of default of the borrower. If a person passes a junk bond as though it is AAA-rated, he's a fraud. How is that any different, really, from passing a bank's gold certificate denominated at $100 that is backed by only $8 in actual gold?

  Published: December 31, 2006 11:58 AM