Comments (30)

• Max123

  Good site

  Published: December 24, 2007 1:32 PM

• Ken Zahringer

  "Wonderful Life" is one of my wife's favorite Christmas movies, so I've seen it more times than I can count. I think the bulk of your criticisms are right on the mark, but I want to debate one issue. I don't think George Bailey was a fractional reserve banker. Here's why:

  Let's look at the bank run scene. Obviously the town bank was using fractional reserves, or they would not have needed to call in Bailey's loan, which I suppose was an operating line of credit, to try to stave off the run. The fact that it was more economical for the Baileys to use credit for operating expenses rather than retained earnings again smacks of government intervention resulting in artificially low interest rates.

  But what was George's first response when faced with a request for cash? He has the patron fill out a form, promising his money in 90 days, saying "that's what you agreed to when you bought your shares." He was apparently acting according to a contractual agreement. He then goes on to explain in detail how the building and loan worked, and why it wasn't a money warehouse. In short, the patrons' accounts were explicitly NOT demand deposits. Given George's use of the term "shares", they may well have been equity investments. When George uses his personal funds to satisfy his patrons' demands, he again explicitly states that he is making a loan, not cashing out their shares, so he never has to admit that their demand for immediate redemption is valid. He's just doing it out of the goodness of his heart (gag me!), not to mention staving off a hostile takeover attempt by Potter.

  I would also say that eschewing fractional reserve banking helps explain why, as the owner, he is only making $35 a week. That was pretty good in the mid-1930s, but he sure wasn't getting rich.

  I'm probably giving Capra way too much credit, but it seems that this scene, like the rest of the movie, serves to show what a Great Guy George is because first, he is running his business honestly and second, he uses his own money to help out the townspeople when he isn't obligated to. This, of course, contrasts with Potter, and supports Potter's opinion of the Baileys as "no businessmen" since George didn't cheat people as a daily business tactic, and he didn't tell them "Root, hog, or die" when they came to him for help. All of which is, in Capra's world, standard capitalism.

  Geez, what a sappy movie.

  Your thoughts?

  Published: December 24, 2007 2:02 PM

• Mike Sproul

  Ken:

  It's nice, once in awhile, to see someone on this website who understands that fractional reserve banking is not fraudulent as long as the bank and its customers agree to it. It's very strange that libertarians should oppose a practice that is nothing but a voluntary exchange.

  Published: December 25, 2007 10:56 AM

• George Gaskell

  The antidote to fraud is disclosure.

  Therefore, fractional reserve banking is fraudulent as between the bank and its customer, to the extent that the account is promoted as though it were a "demand deposit," when in fact it is merely an unsecured loan.

  It is therefore also fraudulent on a secondary level, as between the bank customer and the person to whom the customer passes a bank note issued against his account. It is not a bearer note for a demand deposit; it is a note for an unsecured loan, and should identify itself as such on its face.

  Published: December 25, 2007 11:17 AM

• Fred Mann

  Are there any non-fractional-reserve banks out there?

  Published: December 25, 2007 12:17 PM

• Mike Sproul

  There was the Bank of Amsterdam, established in 1609, which Adam Smith described in the Wealth of Nations. Henry Thornton (1801) also talked about how it failed, and why a 100% reserve bank isn't as safe as gold bugs often claim.

  And of course, since virtually every bank nowadays operates on fractional reserves, it is unnecessary to have bankers and customers sign detailed contracts specifying exactly how the fractional reserve system operates, for the same reason we don't sign detailed contracts specifying the exact ingredients of everything we buy at the grocery store.

  Published: December 25, 2007 2:30 PM

• DavidB

  fractional reserve banking is not fraudulent as long as the bank and its customers agree to it.

  Excuse me? And where is my, the non customer's choice in this fraudulent transaction when these two conspire to create money out of thin air and dilute my currency that I have labored hard to save over the years?

  You seem not to mention that there is a fiat currency in operation here the I am virtually forced to use to make transactions with. I could refuse to use the currency but then my economic freedom is drastically curtailed

  Published: December 25, 2007 6:36 PM

• David White

  Mike Sproul:

  Your point is purely academic, as DavidB points out. Yes, in a truly free market, fractional-reserve banking could exist on a contractual basis. What libertarians rightly oppose is "Centralization of credit in the banks of the state, by means of a national bank with state capital and an exclusive monopoly."

  http://www.anu.edu.au/polsci/marx/classics/manifesto.html#Proletarian

  Surely you agree, and are supporting Ron Paul accordingly.

  Published: December 25, 2007 8:08 PM

• Fred Mann

  I was also wondering if it's even possible ("legal") to run a bank today in the USA without being forced into the federal reserve system.
  Also Mike, Rothbard was specifically NOT against allowing fractional reserve banking to exist as an option alongside full-reserve banking. But of course full-reserve banking must be allowed, and governments can not be allowed to use force to maintain the federal reserve cartel.
  Oh, and old man Potter may simply have inherited his money, or gotten it through government contract work, etc. so he may not be of any use to society after all...

  Published: December 25, 2007 9:13 PM

• Mike Sproul

  Fred and David(s)

  My points of disagreement are:
  1) Money is not created out of thin air, but as receipts for assets held by the money-issuing institution, be it the Fed or a private bank.
  2) There is no such thing as fiat money. The paper dollar, for example, is physically inconvertible, but it is still backed by the assets of the Fed, and it is financially convertible.
  3) I attended a seminar in 1994 or so, where Rothbard said that fractional reserve banks are essentially counterfeiters, and the Fed is just the head counterfeiter. When I asked if fractional reserve banking was fraudulent even if both parties agree to it, he answered that "They don't know what they are agreeing to."
  4) I do agree that the Fed should not have a monopoly on the issue of paper money.

  The points above are based on the real bills doctrine, which is explained at

  www.csun.edu/~hceco008/realbills.htm

  Published: December 25, 2007 11:10 PM

• D. Saul Weiner

  Lew's piece was brilliant, and even more timely today in light of the progress being made via the Ron Paul campaign. Rereading it also made me realize that Lew's analysis was most likely what inspired my most recent contribution to LewRockwell.com (though it had a different angle)!

  Published: December 25, 2007 11:42 PM

• Joseph Huang

  i agree that money is not created out of thin air. it is created out of computer storage and thin paper.

  a dollar bill is not a receit for $1 worth of a bank's assets. a dollar bill is not convertible into a dollar's worth of gold, or any other resource, by the bank. altho the bank can sell its assets, the proceeds of those sales do not go to dollar holders, they go to the bank.

  will you accept my dollars then? i promise to repay you nothing, but i will make myself better off at your expense. since i make myself better off, it is not really "fiat", it is still backed by my assets even tho its not convertible. if i go bankrupt, i won't owe you a dime, but my dollar still has value. mmkay?

  Published: December 26, 2007 8:10 AM

• DS

  I am pursuaded by what Ken Zharinger said:

  What George Baily was running was not a fractional reserve bank but a "Building and Loan" where the members purchased shares that spelled out the stipulations of when they could get their money, but contractual agreement.

  Potter on the other hand was running a fractional reserve bank, making him NOT a hero in these parts.

  Of course 99% of the public, including people who are well trained in the financial world, don't know how fractional reserve banking really works, unlike the share purchasers of the Bailey Building and Loan.

  Is that fraudulent? I don't know, but that FRB is sustained by public ignorance of it's true character raises a lot of suspicion. I suppose you could make some sort of argument that it's the depositor's fault for not knowing anything about the institution they are giving their money to. The banking system as it exists is based on a combination of faith and ignorance. If that combination reverses itself there is no amount of government insurance and backing that will keep the depositors money from disappearing.

  Published: December 26, 2007 8:16 AM

• Joseph Huang

  and the dollar is backed by force. see legal tender laws. also see that taxes must be paid in US dollars.

  Published: December 26, 2007 8:25 AM

• Michael A. Clem

  Mike Sproul will not be so easily converted from RBD, but arguing with him does help provide clarity about banking. As others have pointed out, the value of the dollar is not based upon its backing, but on the amount of dollars in proportion to the available goods and services that can be purchased with it. The point of commodity banking, gold or silver or what-have-you, is to place limits on the amount of currency that can be issued. Thus, if one deposits an asset with a bank, they can issue new currency based on the value of that asset.
  
  Key point for RBD and the rest of us: what is an asset? Mr. Sproul thinks that debt is an asset and issuing currency based on that debt does not cause inflation. If the asset were some kind of productive good, then the available goods and services that could be bought with currency would increase in step with the currency. But if the asset is debt, is it a productive good? Debt can obviously be bought and sold, but the value of any debt is based upon the borrower's ability to be productive in the future, earn money, and then pay that debt back. Collateral is the backing for the loan, but it is not the backing for the issuance of new money. Debt is not a productive good, but the potential of future productivity. Thus, debt-backed money has real and inherent risks, and isn't a very strong limit on the amount of currency that can be issued.

  Published: December 26, 2007 10:40 AM

• Mike Sproul

  The real bills doctrine simply says that if anyone, including a central bank, issues pieces of paper called dollars, pesos, etc., then the value of those dollars depends on the assets and liabilities of whoever issued them. The quantity theory, in contrast, makes the incredible proposition that the value of those dollars does not depend on the assets and liabilities of the person who issued them, but on the quantity of goods produced by other people. The QT also implies, for example, that if the dollar started to be widely used in Mexico, then the peso would fall, and the Fed could earn a free lunch by issuing those dollars. This raises the question of how so many countries manage to maintain any value at all for their currencies, since all countries would be trying to circulate their money as widely as possible, in order to get that free lunch. The real bills view is that the value of every country's currency is maintained by the fact that its central bank holds backing for the currency. Thus there is no free lunch from the issue of money, and the numerous puzzles raised by the quantity theory disappear.

  Published: December 26, 2007 12:32 PM

• Michael A. Clem

  Well, there is this pesky thing called subjective valuation--you may have heard about it somewhere. The change in prices due to changes in the currency theory only holds true if other variables, such as how people subjectively value money, doesn't change. Subjective valuation also explains why the backing of an asset doesn't fix the value of currency. The "free lunch" is an illusion, a short-term benefit/theft that occurs only as long as those subjective evaluators are unaware that it's happening.

  Published: December 26, 2007 1:39 PM

• DS

  "This raises the question of how so many countries manage to maintain any value at all for their currencies, since all countries would be trying to circulate their money as widely as possible, in order to get that free lunch. "

  Simple: Because all of these countries are measuring the value of their currencies against all the other fiat currencies in the world, not versus a fixed value. So if the Fed creates money out of thin air and the Chinese central bank creates the right amount of fiat currency out of thin air, their relative values will remain the same. If the Fed creates a little more fiat currency than the ECB then the value of the dollar will fall slightly, but both central banks are creating money out of thin air, just at different rates (the ECB nor any other central banks ever retire money). To those who don't understand or purposely try to conseal the true process, this looks like no inflation has been created. But the wrong thing is being measured.

  The fly in the ointment is that real goods and services aren't fooled by this process, the price of gold, oil, the CRB index, agricultural commodities, etc. do not have the capacity to respond to philosophical arguments about what does and doesn't constitute an "asset" on a bank balance sheet. They simply respond to the amount of money chasing the limited supply of these goods. The fact is that global competition and productivity has increased and the costs of numerous manufactured items have decreased over the past decade or two. Yet we have still had inflation instead of the natural deflation that should be occurring, this is just one more piece of evidence that money is being created at an alarming rate.

  Let's not forget that pure, inconvertible, global fiat currency is a worldwide phenomenon that is less than 40 years old. This unstable system has been maintained for this long partly because everybody in the central banking world got a big scare in the 1970's and some of those people are still around. For a time they tried to create fiat currency conservatively, as if it really were linked to gold. But those people are getting old, and have slowly talked themselves into becoming much more confident in their abilities to create money without increasing a narrowly defined goverment statistic at too high a rate. All you have to do is listen to the financial news channels, newspapers, internet commentators and Fed officials to know that most of the painful lessons about inflation have been conveniently forgotten. Hint: whenever I hear things like "...as economic growth slows it will decrease inflationary pressure..." I know I am listening to somebody who either wasn't around in the 1970's or who simply forgot.

  The fact is that everybody wants easy money (the stock market, the bond market, the banks, the government, corporations, consumers, farmers, etc., etc.) as long as they can convince themselves that it isn't harmful.

  But easy fiat money provides euphoria now and pain later. It takes years for the effects to be fully felt, usually when it is too late to do anything other than raise interest rates to 21%.

  Published: December 26, 2007 2:21 PM

• Joseph Huang

  if the RBD is true, why does the dollar get weaker and weaker vs real goods, such as gold and oil?

  Published: December 26, 2007 3:01 PM

• Mike Sproul

  Because the quantity of dollars keeps rising relative to the assets backing it. A quantity theorist would say the dollar keeps falling because the quantity of dollars keeps rising relative to the output of goods and services. The few economists who have tried to test these two views (Sargent, Smith, Cunningham, Bomberger, Makinen, etc.) have found that the asset/backing view fits better than the Quantity Theory view.

  www.csun.edu/~hceco008/realbills.htm

  Published: December 26, 2007 3:56 PM

• Joseph Huang

  then it is not backed at all. an ever-moving inch is not a measurement of length, and an ever-moving "backing" is not a real backing.

  the bank does not back dollars with their own assets, because the bank does not agree to exchange dollars for bank assets on demand. they only agree to exchange dollars for dollars.

  Published: December 26, 2007 4:05 PM

• Joseph Huang

  what if i owed you $20. would you say that i can just print $20, then give you $20, and make myself $20 richer, and pay off the det? would i really owe you $20 worth of my assets after printing the $20? to think of such things is to think nonsense.

  Published: December 26, 2007 4:08 PM

• jp

  Mike,
  About your comment on financial convertibility. It is true that the dollar can be converted into what backs it - government bonds - but don't you think this point should have a few asterisks behind it?

  You and me can't turn our dollars into the Fed for bonds, only the primary dealers with access to open market operations can. Even then, they can't just flip their dollars for bonds, they have to wait for the Fed to initiate open market operations, specifically sales. The Fed has only engaged in a few open market sales in the last decade, their bias is toward purchases. So yes, in theory I see what you mean when you talk about financial convertibility, but in practice this is somewhat limited.

  Published: December 26, 2007 5:15 PM

• Mike Sproul

  JP:

  It's true that financial convertibility is at the Fed's option (unless you're a bank who borrowed thru the discount window--then you can choose the time to repay your loan, that is, to give the Fed dollars in exchange for your IOU.) In a growing economy, the money supply should grow too, so it's no surprise that the Fed rarely sells bonds. Instead, when the demand for cash grows relatively slowly, the Fed simply buys fewer bonds than usual.

  Of course, if the Fed's goal is to avoid inflation, then whenever they sense inflationary pressure the Fed will start to buy fewer bonds, so the fact that the public cannot initiate the return of dollars to the Fed is less significant.
  This is one reason to favor private issue of paper money--so the quantity of paper money will be controlled more by the public, and not by the Fed.

  Published: December 26, 2007 8:51 PM

• DS

  jp,

  The whole point about convertibility is this: if the money you hold loses value due to an excess of it in circulation then you can trade it in for something of a fixed value, usually gold, at a fixed exchange rate. This way you maintain the value of the money you have earned. This is the essence of a commodity backed currency. It makes it a pointless exercise for the government to simply print money to create revenue. A drop in the value of the gold would result in all of the dollars being traded in and all of the gold in the vaults at the Fed being drained and held by the public. This is why every war in the gold standard era began with a suspension of specie payments. In other words the government granted itself the right to print paper money with no convertibility to gold and then passed laws forcing every citizen to use that paper as money (and nothing else).

  If paper money is "backed" by dollar denominated bonds that are valued in dollars and pay dollars as interest, there is really no point in trading them in as the dollars you hold lose value. So you can say that the dollar is "backed" by government debt, but government debt provides no anchor of value whatsoever. In a debt "backed" system you can't even preserve the full value of your hard earned dollars by buying gold, because you have to buy that gold with depreciated dollars.

  The whole point of using money in the first place is that it provides a stable value that can be exchanged reliably between people who agree on it's value. What has been subtly substituted is a currency that drops at a supposedly steady rate every year, though most people don't understand that since the great inflation fighter Alan Greenspan entered office in 1987 the value of the dollar is only half of what it was.

  "Of course, if the Fed's goal is to avoid inflation"

  The Fed's goal is to purposely create inflation at 2%-3% a year, not to avoid it. Despite the "inflation mandate" in the Fed's charter, no Fed chief has ever been driven from office for creating inflation, not even the extremes of Martin or Burns who created the inflation of the 1970's. At best William Miller was asked to resign due to inflation, but it wasn't really his fault - he just did nothing to fix what his predecessors had created. I suspect no Fed chief will ever be removed from office for creating too much inflation.

  Published: December 27, 2007 8:17 AM

• DS

  DS:

  "A drop in the value of the gold would result in all of the dollars being traded in and all of the gold in the vaults at the Fed being drained and held by the public."

  It's the other way around. If a dollar is convertible for 1/35 oz of gold at the Fed, and the DOLLAR loses value, so that on the open market, a dollar is worth 1/36 oz, then everyone would bring their dollars to the Fed to get 1/35 oz, until the Fed loses all its gold.

  (Also, the Fed's charter requires the fed to (1) provide an elastic currency, (2) act as a lender of last resort, and (3) regulate private banks for soundness. The "inflation mandate" came much, much later.)

  Published: December 27, 2007 11:40 AM

• Michael A. Clem

  Because the quantity of dollars keeps rising relative to the assets backing it.
  
  Now that's an interesting twist. You mean, after issuing currency for assets, the bank then turns around and issues more currency on the same assets? Or do the quantity of dollars increase in some other fashion?
  

  Published: December 27, 2007 12:13 PM

• Mike Sproul

  After issuing $100 for $100 worth of assets, the Fed turns around and issues another $100 for another $100 worth of assets. In this case there is no inflation. But if the fed issued $100 for $99 worth of assets, or if the $100 of assets fell in value to $99, or if the fed lent $100 at a discount rate of 4%, when the market rate was 5%, then in each case, the Fed's assets do not keep up with the supply of money, and there will be inflation

  Published: December 28, 2007 12:02 AM

• JohnR

  This whole argument is undercut by the fact that Potter was a thief who stole other people's money instead of returning that which was not his.
  

  Published: December 28, 2007 9:47 AM

• Philip

  I realize that this is almost a year late, but I, too have been bothered by the "economics" of this movie. How am I supposed to see Mr. Potter as the villian, when he apparently provides goods and services that people want--enough so to make him quite wealthy?

  Well, we can glean two things about Mr. Potter that could explain that his wealth did not come from his work in the marketplace. First, he is an unapologetic thief. He sees the money in the folded newspaper, and takes it without a second thought. Second, we see that he is politically connected (Congressmen call him, and he tells them to wait). In other words, he seems to me to be more of a "Political Entrepreneur" than he is a "Market Entrepreneur". Not that he isn't shrewd enough to seize opportunity with both hands; he apparently gains control of most of the town the day of the bank run. I strongly suspect that much of Potter's money is inherited, rather than being earned by himself, and he builds on it through his political machinations. There is, of course, nothing wrong with inherited wealth in itself, but it doesn't make Potter some heroic entrepreneur.

  For the real entrepreneur, I would point to Sam Wainwright, the plastics manufacturer.

  George himself has some qualities that recommend him as a businessman. He is first of all an inveterate saver. He's able to cut costs to the nubbins in order to undercut Potter's prices.
  He relates well to his employees and his customers. He is willing to devote his own resources to ensure the success of his business.

  On the other hand, George gave up his dreams, and probably a successful career as an architect, in order to maintain a legacy business founded by his father. He probably could have helped a lot more people if he had applied his skills and energy to doing what he loved.

  Published: September 30, 2008 8:47 PM