Comments (107)

• Todd

  Thanks for posting that exchange. I too felt that Caplan's casual dismissal of the Austrian perspective on fractional reserve banking was rather flippant. Also, I'm not sure why he would object to rigorously defining ideas like ownership and rights in the context of exploring legal implications of a proposed banking system. Ultimately, it's still not clear to me how he can hold the view that FRB is a good-faith practice when it involves the explicit use of demand-deposits.

  Published: November 1, 2008 9:30 AM

• mitcm

  It is shocking that such a "brilliant" guy like Caplan could be so cavalier in his dismissals and then having nothing to back up his claims. His statements re marital property would be laughable to any first year law student. It seems that his last line of defence is "customary language". That sounds like a great basis for a legal system to me! (Judge: No, sir, I'm sorry, both you and the defendant can fully own that gold ingot. Yes, you both can sell it to whomever you please. No, I'm sorry, you're objections do not hold water as I have never heard the words 'exclusivity' or 'alienation' used in ordinary language)

  Published: November 1, 2008 10:43 AM

• Matěj Šuster

  Money is a fungible good. Depositors do not have a claim to a particular piece of gold. There is thus no logical contradiction / impossibility in FR deposit contract. Two or more people can own a claim to a specified amount of gold without there being any necessary conflict of their rights.

  Published: November 1, 2008 11:04 AM

• Gu Si Fang

  It seems that your position is to assume that the bank's customer wants a 100% warehousing service (bailment contract), in which case you are right to say that FRB is fraudulent. But what if some customers agree to have a fractional reserve account? [I don't know the English word for this, would it be called a lease contract?]

  On the other hand, B.Caplan would probably admit that, under a free market, the bank and its customer would be free to try any contract they please, be it 100% or FRB, so long as the customer is informed and voluntarily accepts the contract.

  What happens then if bank A offers 100% accounts, and bank B offers fractional accounts? Their respective receipts will circulate as competitive currencies, both redeemable, yet not exactly alike. Consumers will be the only judges of the qualities of both currencies. My guess is that A's receipts will be more marketable and would soon outcompete B's receipts, but this can only be determined by letting the free market operate, not by argumentative reasoning.

  Published: November 1, 2008 11:09 AM

• Matěj Šuster

  And by the way, supposing that Walter Block is right, what legal reform does his view imply? Something like "Regulation Q", i. e. statutory zero rate of interest on demand deposits (checking accounts), since demand deposits do not represent "genuine savings" (praxeologically)?

  Published: November 1, 2008 11:15 AM

• Pat

  I second Gu Si Fang's point. I think there is nothing that would require to have a law that prevents fractional-reserve banking in a free banking setting. At worse, it is just a fraud and can be lead to a lawsuit. The other possibility would be that full-reserve banking becomes the norm through customers' choice (How fast can it happen? There is no telling). But Mr. Caplan seems to accept that the concept of central banking is not problematic (To be fair, he stresses that 'independence' of the central bank is far better than having governmental control. But this is done by leaving free banking out of the equation, which fails to give a solid defense of central banking).

  Published: November 1, 2008 11:27 AM

• Mike Sproul

  If I have 100 checking account dollars in a bank, I prefer that the bank not keep 100 paper dollars in its vault on my behalf. The bank would have to charge me storage fees, and the cash would be vulnerable to robbery.
  I prefer that the bank keep 10 paper dollars in its vault, plus an interest-bearing IOU worth $90. That way, the bank can pay me interest, and the IOU is less vulnerable to robbery than cash.
  In keeping with this, I agree before depositing that there will be times when the bank runs low on cash and cannot pay me in paper dollars. This will be a minor inconvenience, but as long as the bank's assets are sufficient to buy back all 100 checking account dollars, I'll live with the problem in exchange for the interest I'm paid.
  Even if the $90 IOU falls in value, and the bank actually can't repay my deposit, I accept that risk, just as I accept other risks.
  The Bank of Amsterdam maintained 100% reserves, but its directors secretly lent some reserves to the city and others. That was, in effect, a theft, and it was not prevented by 100% reserves.
  

  Published: November 1, 2008 11:31 AM

• ktibuk

  "What happens then if bank A offers 100% accounts, and bank B offers fractional accounts? "

  If that is the case, the receipts of the fractional reserve bank would be traded with a discount.

  But at how much of a discount? Does anybody know the exact percentage of the reserves.

  The problem with this "fractional reserve banking" is that even if the people know they put the money in fractional reserve bank, if the bank doesnt forclose all of its reserve percentages all the time, this would effect everyones purchasing power because it creates inflation.

  Lets say you are ok with adding water to milk. But we can not price it unless we know how much water is in the milk exactly. Just knowing there is some amount of water is not enough. Selling milk with 50% water as milk with 10% water is still fradulent.

  Published: November 1, 2008 11:41 AM

• Inquisitor

  Voluntary FRB is fine. That doesn't stop Caplan from being an idiot, though.

  Published: November 1, 2008 12:11 PM

• Oil Shock

  I am not an economist, but Caplan sounds like a jackass. If husband and wife think they each own 100% of the car, how will they divide it when they go through a divorce?

  I don't think there is a need to ban FRB, but I think in a free banking monetary system, banks that tend to overextend themselves in FRB will go bust quickly, and that should be settled in court.

  Published: November 1, 2008 12:51 PM

• greg

  I believe FRB would exist in a free market. The only demand I would place on it is that it is transparent. IOW, when one put their money in the bank, they'd know the implications, and the amount of fractional reserves on their *part investment, part deposit*. So as long as it is voluntary and transparent, I can't see why free market banking would ever strictly prohibit it. Whether it could succeed is another question, but a free-marketeer says let the market decide.

  Then there is the question of "inflation." Sure, it could inflate that bank's notes. So what?. Again, as long as the bank is transparent about its notes -- for example, printing key information on the notes -- then it is hard to see why a taker of the notes is not accepting possible inflation of the notes.

  And if certain people want 100% reserves, then they can pay for the safe storage of their money. That could exist on the free market too.

  Published: November 1, 2008 12:58 PM

• Blah

  I'm afraid that I can't agree with Walter or Rothbard here, even though I usually do: IMHO, Fractional Reserve Banking is not fraud. FRB could exist under a libertarian legal system, if the legal system recognizes that the FRB simply transfers ownership of its reserves to the first depositor who cashes in his claim. Two depositors do not have full ownership; they simply have receipts, and the first depositor to cash in his receipt acquires full ownership; the second depositor receives nothing. So long as the customers were informed of these rules when they signed up, there is no fraud.
  
  Thus, there is no contradiction in the legal system.
  
  However, there is a contradiction in the mind of the fractional-reserve depositor, for he seeks to have his cake and eat it too: He wants protection against uncertainty (i.e. money), but he also wants to be paid for taking risk (i.e. interest). In a free market, it is simple enough for the depositor to put a portion of his money in a full-reserve bank, and invest the rest in bonds, stocks, etc. But instead, he chooses to go for all or nothing. And since fractional-reserve banking leads to business cycles, which lead to panics, which lead to bank runs, our depositor is likely to end up with nothing.
  
  I believe the only reason fractional-reserve banking is still around is because the system has been maintained through violence: Government schemes like banking holidays, deposit insurance, and central banks. But who knows; people would still gamble their money away in casinos in a free market, so perhaps we would still have fractional-reserve banks too.
  

  Published: November 1, 2008 1:30 PM

• cookie

  A great article and comments!

  I am not sure which side of the fence I fall on with regards to this issue (although I lean towards the idea of FRB being legal and letting the market decide the relative merits of the argument), but I would like to thank both of the contributors to this piece and those who have posted comments for making me reconsider my previously held views.

  Published: November 1, 2008 2:56 PM

• Inquisitor

  I think it's important to separate voluntary FRB from central banking. If Caplan sees no problem with the latter, he is no better than a common statist. As an economist he should consider it an outrageous institution.

  Published: November 1, 2008 3:09 PM

• Grant

  Caplan is great on public choice, and is a market anarchist. Despite his nuanced view of political economics, he seems to interpret Austrian economics both broadly and incorrectly.

  Perhaps he simply views neoclassical econ as having already incorporated all of the Austrian insights he agrees with?

  Published: November 1, 2008 3:40 PM

• Mike Sproul

  Blah:
  "Two depositors do not have full ownership; they simply have receipts, and the first depositor to cash in his receipt acquires full ownership; the second depositor receives nothing. So long as the customers were informed of these rules when they signed up, there is no fraud."

  If two depositors each have 50 checking account dollars, and if the bank holds 50 paper dollars plus a $50 IOU, then the first depositor gets 50 paper dollars, while the second either gets the $50 IOU, or else waits for the bank to sell the $50 IOU for 50 paper dollars. The only time someone ends up with nothing is if the bank is insolvent.

  Published: November 1, 2008 3:45 PM

• Mike Sproul

  Greg:
  "Then there is the question of "inflation." Sure, it could inflate that bank's notes. So what?."

  Normally, fractional reserves won't cause inflation. If a bank accepts 10 paper dollars on deposit, and issues 10 checking account dollars, and if that bank then lends 90 checking account dollars to a farmer, and receives that farmer's $90 IOU, plus a lien on the farm, then the bank's checking account dollars will each be worth 1 paper dollar. After all, the banker could, if he chose, sell the $90 IOU for 90 paper dollars, and then he'd have 100 paper dollars backing 100 checking account dollars.

  Published: November 1, 2008 3:53 PM

• scineram

  I agree, the comments are surprisingly good.

  Caplan can be an ass, but he is an anarchist. He opposes central banking and wants to freeze the monetary base, see his purity test. So do I.

  Published: November 1, 2008 4:18 PM

• Ball

  When I was reading De Soto's "Money, Bank Credit, and Economic Cycles," I thought the author spent far too much time pounding away at this issue as his point seemed so obvious to me. Apparently, it isn't so obvious to everyone.

  I hope this 'debate' doesn't get drowned in semantics. I'd rather pose the question: If I have $1000 in the bank, how much do I have in the bank? Can anyone of Caplan's persuasion honestly answer that question?

  Published: November 1, 2008 4:38 PM

• Oil Shock

  first depositor gets 50 paper dollars, while the second either gets the $50 IOU

  The second person receives a small piece of the subprime loan that was defaulted a few months ago.

  Published: November 1, 2008 4:59 PM

• Stanley Pinchak

  Ball,
  you have $1000, but only if you get to it before the other 9 people do. Let me put this another way, you have $1000 dollars until you attempt to redeem your fiduciary media. So i guess you have to ask Schrödinger's cat. Is it better not to know that your bank is insolvent than to go to the teller and remove all doubt?

  Published: November 1, 2008 5:11 PM

• Brian Macker

  "The second person receives a small piece of the subprime loan that was defaulted a few months ago."

  Or part of an asset that had inflated in price due to the fractional reserve banking increasing the money supply.

  Which is something that I don't think most people are competent enough to grasp. Giving their money to the fractional reserve bank sets up the convoluted course of events that will eventually lead to that bank collapsing during a run.

  The fraud lies in the fact that those exact same people who claim to be competent in making such contracts are the first to turn to taxation to "correct" a bank run.

  The very fact that most people expect the government to bail out banks during runs shows they don't truly understand the contract even if it is clear.

  How can we truly say that such contracts are valid when the empircial evidence is that so few understand them?
  

  Published: November 1, 2008 5:20 PM

• Brian Macker

  "Normally, fractional reserves won't cause inflation."

  Which kind of inflation you talking about here? Fractional reserve won't cause fiat monetary inflation, or price inflation driven by fiat monetary inflation. It will however cause fractional reserve driven monetary inflation and the price inflation that follows.

  Fiat inflation is caused merely by lowering reserve levels. Reserves are lowered with confidence and what can make one more confident than a booming economy due to fiat monetary inflation. It's a self reinforcing process and therefore unstable.

  Any increase in confidenced that risks are lower can lead to a lowering of reserves held. So the ending of a war, a boost in productivity, the opening trade with new partners, can all cause the push that starts the roller coaster on it's up trip.

  "After all, the banker could, if he chose, sell the $90 IOU for 90 paper dollars, and then he'd have 100 paper dollars backing 100 checking account dollars. "

  Not if everyone else is trying to do the same thing at the same time. Which is guaranteed by the coordination of error that is implicit in fraction reserve banking.

  Published: November 1, 2008 5:42 PM

• Ball

  So do I have $1000 while it is in the bank, or not? What of the other 9 people?

  I don't understand how people like Caplan can be so "intelligent" and not understand such fundamentals. What is he anyway, one of those crazy RBD proponents?
  
  To deceive oneself to such a degree must take great intelligence indeed!

  Published: November 1, 2008 6:23 PM

• scineram

  You have nothing in the bank. The bank owes you 1000 dollars.

  Published: November 1, 2008 6:50 PM

• Brian Macker

  The bank owes you 1000 dollars."

  The bank owes him and a thousand other people a thousand dollars on demand and only keeps cash on hand to satisfy 2% of those claims.

  If 2% of those people decide to pull it all out there is no more reserves. At which point the bank will need to sell it's mortgages to other banks to raise cash. Which isn't happening if they are having the same problem because of a downturn.

  So the other option is what? Call in the loans and sell the underlying assets. However that too cannot raise the required cash because dumping assets on the market simultaneously drives the prices down. Besides their is by definition already a shortage of cash, a deleveraging of the money supply and nobody has the cash to actually buy those assets.

  This all because you can't borrow short term and lend long term without commiting a fraud of sorts. The bank runs during the downturn is the exposure of the fraud. The banks never did have a way of raising the cash to pay off all those short term promises after all.

  In aggregate it's an impossibility even if in theory it is possible for any one transaction.

  Published: November 1, 2008 7:10 PM

• Kyle

  The real question is who has title to the specie. If the depositor retains title to it, the bank is obligated to hold it at ready at all times.

  If on the other hand, he makes a loan to the bank, accepting their IOU, which they will make an attempt to repay at your request. There could be all kinds of terms protecting both parties, with better rates for more control granted to the bank.

  The critiques of frb refer only to the first situation where a deposit is made as a bailment.

  The real issue is ownership. Either the bank owns the money, and you own an IOU, or you own the money and the bank acts as a bailee. Block's criticism amounts to the fact that one of the two must be the case. We can't both own it.

  Published: November 1, 2008 7:28 PM

• Ball

  Kyle, oh, but there's always option three. The cake exists on my plate AND in my stomach!

  Published: November 1, 2008 7:36 PM

• Pierre

  It is silly to say that "The critiques of frb refer only to deposits" and not to loans. Of course it doesn't refer to callable loans, those are real savings.

  Deposit/checking accounts are not savings, their purpose is to facilitate consumption.
  If the bank owns the money, it's a loan (callable or not). If the client owns the money, it's a deposit.
  Please carefully read Money, Bank Credit, and Economic Cycles before criticizing 100% reserve banking or you won't know when you're setting up straw men and when you're making legitimate criticisms.

  Published: November 1, 2008 7:50 PM

• Mike Sproul

  Oil Shock:
  Nobody denies that IF the IOU was defaulted upon, then the checking account dollars issued by the bank will lose value. The same would be true of a 100% reserve bank that lost some of its assets. But a bank that holds assets worth $100, as backing for 100 checking account dollars, is able to buy back its checking account dollars at par. It is the value of the bank's assets that matters--not their physical form.

  Brian Macker:
  You are assuming that price inflation results when there is more money chasing the same goods. Consider the other view: That if a bank issues 10% more money at the same time that the bank acquires 10% more assets, the money will hold its value. That relation is true of every financial security. It takes some pretty tortured logic to assert that it does not hold for money.

  Published: November 1, 2008 9:57 PM

• Stanley Pinchak

  Pierre,
  This is an excellent observation and reminded me of an article recently mentioned on the blog by Hulsmann, "Toward a General Theory of Error Cycles." In this article, Hulsmann brings up the problems associated with mitigating the troubles of fractional reserve banking. He references the Progression Theorem as outlined by Rothbard and Salerno. I have not had a chance to examine this literature, but it should prove enlightening to the subject at hand. Furthermore, Hulsmann briefly shows that many of the schemes attempting to skirt the issue of fractional reserve banking on demand deposits result in what are essentially time deposits and do not address the fundamental ownership problems of fractional reserve banking.

  Published: November 1, 2008 10:03 PM

• newson

  to Matěj Šuster:
  de soto describes the deposit of fungible goods as a "irregular" deposit contract. whilst depositors do not expect to withdrawn the exact same coins or gold bars (or wheat grains, for that matter), they do expect to all get back the exact same amount as they deposited. that is deposited, not loaned.
  and yes, current accounts should not accrue interest (and indeed here in australia that is still the case notwithstanding frb - a double fraud!).
  interest bearing accounts are loans to the bank, not deposits, and have distinct and explicit durations.

  
  

  Published: November 1, 2008 10:04 PM

• newson

  to inquisitor:
  you're widely-read on things austrian; i cannot see how you can be so tolerant of frb. i know mises thought inflation, caused through frb, would be fairly contained via interbank redemptions, but i cannot find one instance in history that supports this contention.
  even without a central bank, private banks inflated together and then when it hit the fan big-time, they got the government to suspend specie withdrawal, or resorted to some other protective ruse. central banks only formalized and legitimized what were previously ad hoc measures.

  i would ask how anyone could justify mises' utilitarian view without running into the very same calculation dead-end that he and hayek are famous for highlighting.

  i find the rothbard/de soto/hoppe/hulsmann/ block view much more defensible - if it's fraud, it's intolerable, regardless. no austrian could possibly turn a blind eye to petty theft on account of the costs of prosecution etc.

  Published: November 1, 2008 10:08 PM

• newson

  caplan on marriage and ownership...where to start? perhaps with "when harry met sally". this scene still makes me laugh:

  Harry Burns: Right now everything is great, everyone is happy, everyone is in love and that is wonderful. But you gotta know that sooner or later you're gonna be screaming at each other about who's gonna get this dish. This eight dollar dish will cost you a thousand dollars in phone calls to the legal firm of That's Mine, This Is Yours.
  Marie: Harry.
  Harry Burns: Please, Jess, Marie. Do me a favor, for your own good, put your name in your books right now before they get mixed up and you won't know whose is whose. 'Cause someday, believe it or not, you'll go 15 rounds over who's gonna get this coffee table. This stupid, wagon wheel, Roy Rogers, garage sale COFFEE TABLE.
  Jess: I thought you liked it?
  Harry Burns: I was being nice.

  frb fans take note. ownership counts.
  

  Published: November 1, 2008 10:27 PM

• Brian Macker

  "Consider the other view: That if a bank issues 10% more money at the same time that the bank acquires 10% more assets, the money will hold its value. That relation is true of every financial security. It takes some pretty tortured logic to assert that it does not hold for money."

  I'm not speaking of the action of one bank. Surely if one bank issues 10% more money to buy and asset from another bank it would be a wash.

  What I'm speaking of is collective action. I'm sure your familiar with the phrase "But what if everybody behaved the same way".

  Also I was speaking of reserves, not merely the issuing of 10% more money. If banks dropped their collective reserves from 50% to 47.62% that would cause a collective increase in the issuance of money by 10%.

  How's that possible you might inquire. Isn't that merely an increase in money issued of 2.38%? Well, no. Initially each bank will buy assets worth 2.38%, but then that money will eventually make it back into the banks as new deposits and 52.38% of that will need to be loaned out in order to keep reserve levels at the desired 47.62%.

  It's the iterative process that increases the money supply way beyond expectation.

  With bank reserves of around 4% it takes a minuscule change in reserve amounts to cause a 10% increase in the money supply. Drop the reserve by four tenths of a percent and you get a 10% increase in the money supply.

  One can do this rather rapidly and there is no need to generate any additional goods to create the new money. The extra money is indeed chasing the same amount of goods. Thus the price inflation.

  Worse yet the price inflation is not uniform. It arises first in those goods that banks lend out money to buy. The effect of the extra money is to make savings appear larger than what it is in reality. This lowers interest rates and makes long term projects appear more profitable. Thus the money is diverted to future projects in preference to shorter term ones.

  Because the banks are concentrating on one slice of assets (long term ones) they are in fact overbidding for them in the process of the distortion. They are really getting assets worth less than the money they've committed.

  They are worth less that what is paid because the under priced interest rates do not truly reflect the consumers valuations of the assets.

  In the end there is less value in the structure of production produced because of the time mismatch from what consumers wanted. Consumers wanted more goods sooner and less goods later. They weren't willing to wait for the long term loans to be paid off and you get bank runs.

  This is what one would expect to happen if you think in terms of banks borrowing short term and lending long term. So there is no tortured logic required. It all adds up.

  I, of course, was going with your idea that banks buy assets. That is, in fact, not the case. They just lend out the cash and are not in reality the owners of the assets that are purchased.

  
  

  Published: November 1, 2008 11:30 PM

• Seiferoth

  Lending out more money than one has is a fraud, plain and simple.

  It is not an example of the free market to give people the choice to be party to a fraud -an illegal act- just as it would not be an action of the free market if citizens signed a paper allowing them to be murdered upon certain conditions!

  Governments preventing banks from fraudulent activity are not regulating banks any more than police who enforce murder laws are regulating social activity.

  Published: November 2, 2008 12:36 AM

• scineram

  But noone does that, plain and simple.

  Published: November 2, 2008 4:42 AM

• jason4liberty

  Rothbard's "The Panic of 1819" describes the result of allowing fractional reserve banking very well. Empirically. The banks lent out more money than they had (notes). These notes competed to speculate on land, fueling a land (and goods) bubble. Prices doubled. Then the wheels started to come off the bus. People started trying to collect their specie (since thankfully they were still on a gold standard), and the banks couldn't pay. The banks immediately started trying to call their loans, but the debtors couldn't pay because the land and goods had halved in price. All kinds of interventionist measure were debated and tried (stays of loan execution, repudiation of specie obligation, issue of nonredeemable media ((fiat money)), moral suasion, forced renegotiation of contract), it all failed to stem the crises. The economy survived because of the underlying stability of the specie standard and a return to honoring contract. I have been startled how much of exactly what the US is doing now was done in 1819, two hundred years ago. But we don't learn. "This is a different world, with a different economy! The old rules don't apply." That is what they said in 1819, too. And guess what, the rules still applied. Fraud is fraud. And also, the person that is defrauded isn't the depositor (with full disclosure), the depositor and the banker conspire to commit fraud on the third party to whom the "funds" are loaned.

  Published: November 2, 2008 6:19 AM

• Brian Macker

  Your web site threw away my comment merely because I did not have my name and email address. I cannot retreive it now. The MS Internet Explorer does not keep the text after you get that error message for some reason.

  I don't know exactly how it happened because when I tried it with this message it didn't happen.

  In my original message I discussed why Hummel and Caplan were wrong to be so sanguine about seniorage under fractional reserve, and happy about a 2-3% inflation rate in the aftermath of Reagan/Thatcher.

  The real signals of market intervention were there during the entire period they are happy with. It was obvious that Alan Greenspan was tricked by the deflationary pressures of the productivity gains to set interest rates way below market. The signals being 1) Market mania 2) Low savings 3) High borrowing 3) Asset inflation 4) Large Trade Deficit etc.

  The largest signal staring them in the face that something was done wrong being the current financial crisis.

  How can they sit there all smirky about how great the central banks are running in the current situation. Hell, I was upset with the way things were going back during the internet. It was obvious we were in a classic Austrian Business Cycle boom. An extreme one.

  Published: November 2, 2008 8:57 AM

• Alexanka

  So Brian Caplan is a rising star of neo-classical economics? It says a lot about both neo-classics and Mr. Caplan himself. What he says is not only conflict in rights, it’s worse, it’s a huge logical error. He actually means that A/2=2A ! This trick is possible in Cantor’s world of infinite sets, not this sad planet we are living on.
  Let’s look at his family car example closer. If every spouse has 100% right on the car, every of them can sell it, yes? So the wife is like “Hey Brian, where the bloody machine is? I need it to drive to my fitness center” “I’ve sold it.” “What? Not asking me?!” But it is not a contradiction from Caplan’s point of view. Really, if the wife has 100% right on the car, she can sell it too! At the same money. So as their son. And if it is a family of ten they can sell it ten times! In this way their second-hand VW is turning into Ferrari. But quite a strange kind of Ferrari, one which you can squeeze ten drivers into and all of them can drive in ten different directions simultaneously!
  I wonder would Mr. Caplan be happy to live in his fantastic world?
  

  Published: November 2, 2008 9:25 AM

• Mike Sproul

  Brian Macker:
  "'Im not speaking of the action of one bank. Surely if one bank issues 10% more money to buy and asset from another bank it would be a wash."

  I'm not speaking of one bank either. If the entire banking system issues 10% more checking account dollars, and at the same time gets 10% more assets, then the money will hold its value. If the fed expands its issue of paper money by 10%, then the fed normally gets 10% more assets in exchange, and the paper dollars will hold their value. By analogy: Suppose IBM shares sell for $80 each. IBM can issue 1000 more shares to the public, selling each share for $80. IBM's assets will rise by $80,000, while its shares increase by 1000. IBM is still worth $80 per share, even though there are now 'more shares chasing the same goods'. Furthermore, option writers can write call options on these shares, and short-sellers can issue hypothecated shares of IBM stock. Both of these actions increase the number of derivative shares of IBM, but they have no effect on IBM's assets or liabilities, so IBM shares are still unaffected.

  A checking account dollar is a call option on a paper dollar, or it could be thought of as a hypothecated dollar. The issue of derivative stocks does not affect the value of the base stock, and the issue of derivative dollars does not affect the value of the base dollars.

  "I, of course, was going with your idea that banks buy assets. That is, in fact, not the case. They just lend out the cash and are not in reality the owners of the assets that are purchased."

  If I borrow $100,000 from a bank, and don't repay it, the bank will, in fact, become the owner of my house.

  Click on my name above to learn about the real bills doctrine, which correctly explains the process of money creation, and the determinants of money's value.

  Published: November 2, 2008 9:29 AM

• Omer Admani

  I have a few questions regarding economics. It would be very thankful if someone can answer! I can't find these answers online and it would be very helpful if someone can clarify some concepts.
  1) When India imports from America (as an example), how does the money transfer occur? That is, the buyer in India pays the to the seller in America in rupee, that the rupee comes all the way to the US bank, which converts it to Dollar and than provides the seller in dollars? Or is it that the rupee is directly converted to dollar in India and the dollar comes in the US (thus resulting in a decrease of supply of dollars in India)?

  2)When an Indian seller exports to an American buyer, does the dollar from America go to the Indian bank, which then transfers the dollar into rupee (thus increasing in the supply of dollar? Or is it that the bank in the US keeps the dollar and the rupee is transfered back to the Bank in India?

  3)How does precisely the trade deficit have any impact on the value of the Indian rupee? If the demand and supply of dollars above is not changed (one scenario in each case above if it is true)?
  4)How does this deficit become a "liability" (or indeed how does a current account deficit as well become a liability)? You produce and sell something to another country, and are paid, and vice versa, so how does this eventually turn out to be a liability (it seemed nothing is owed here, the money and the goods have already exchanged hands?? Also, cumulative current accounts balance means that the the balance carries over to the next year? If so, what balance this is in "real terms" because all the goods, services, and cash has already changed hands, there is surely nothing owed?)
  5)Lastly, how does a central bank in a country build its reserves. For instance, India's reserves had grown exponentially. How did these dollar reserves come to grow? Did the central bank purchase USD at some international scale where they sold something other like gold? I fail to see how the reserves can increase so dramatically (even if dollar demand and supply case in 1 is true, India has a trade deficit, thus resulting in a net outflow of dollar, so how did the central bank still increase the reserves despite a net outflow of dollars during the year? Did it buy at an international scale, either from China or the US govt? And if so, in exchange of what, rupee or gold, or something other?

  Published: November 2, 2008 10:51 AM

• Isaac

  Block seems to ignore the possibility of banks in a truly free market offering consumers fractional reserve under clearly defined contracts.

  This could be compared to a faculty parking lot at a university where there were more faculty than spots. Each faculty member knew this, and knew that when they purchased their parking pass they were not buying a gaurantee of a spot, but they were buying basically a "fishing license" to come and attempt to get a spot, knowing the odds of every prof. fishing for a spot at the same time were extremely remote.

  Likewise, frb in a free market would be more like an investment, or even lottery than a "safe". Customers could trade x amount of money for a certificate that allows them to attempt to retrieve x amount on demand, so long as it's there. They would no doubt want to know what percent was in reserve, and what the (rough) odds were they'd get it on demand. Why would anyone do this instead of a 100% bank? Same reason the faculty chose to buy a "fishing" certificate rather than an iondividual spot - because they got such a better deal when they took the remote risk that there would not be a spot. Interest rates would entice some to do FRB instead of 100% backed. It would be another investment vehicle, rather than a "bank" per se.

  I don't see why this is not a valid possibility under free banking. It's possible that consumers wouldn't like it, but then again, they play the lottery, invest in stocks, etc.

  Published: November 2, 2008 11:02 AM

• Isaac

  As described above, there would be no contradiction contractually. Two people would not both have contracts for the same oz. of gold. They would both have tickets that allow them to attempt to redeem said amount of gold. A "fishing" license, or lottery ticket. not a claim to a specific amount of money, just the chance to it.

  Published: November 2, 2008 11:04 AM

• Ball

  Omer Admani,

  How are any of those questions topical?

  I'll answer them briefly, but you should post on the forum instead.

  1) There is no such thing as converting fiat currencies. You can exchange currencies, but conversion hasn't been possible since the gold standard (i.e. when everyone used one currency). Rupees don't travel anywhere, either. We have money markets where rights over existing reserves are exchanged. These reserves tend to be 100% reserve unlike lending institutions (due to the immediate necessity that everything be liquid).

  2) See above

  3) The trade deficit has no immediate impact on supply of or demand for money—it is the other way around. A weak currency can drive a so-called 'positive' balance of trade and vice versa. Also, easy credit can drive out production to foreign countries (typical in empires like the Spanish Empire or the US one) which creates a trade deficit and a weak currency. I will note that there is nothing inherently positive about a 'positive' balance of trade or vice versa. Schemes to affect trade balances will only affect production negatively and impoverish everyone.

  4) Again, you have things the wrong way around. There is nothing inherent about a trade 'imbalance' which causes a liability. All it means is one country relative to another, values promises of FUTURE goods more than PRESENT goods. This is also reflected in the general rate of interest. The general rate of interest is the degree that the market values present goods over future goods, so you can see how it can drive trade 'imbalances'.

  5) India's reserves grow because they are selling goods to the USA for dollars. Why they do this is rather convoluted, because they can't buy many things with those dollars. They can buy US debt, US companies/capital/land, and US politicians (which all occur). A lot of it, however, it ends up as some kind of 'reserve', which in a free market would mean goods could be bought in the future. No Austrian economist sees this happening, though. Instead, these dollars will become worthless and India will scorn the advice given to them by the IMF and World Bank.

  Published: November 2, 2008 12:00 PM

• Giy

  If my son learn to saving his money--just saving money, I think he get bad idea from Mr Caplan. So, he must learn between saving money and money investment.

  Published: November 2, 2008 12:08 PM

• Dan Mahoney

  Bryan Caplan demonstrates once again that being highly intelligent and a complete fool are not incompatible attributes.

  But I am puzzled by the libertarian defenders of FRB; they remind me of a man who admits that, yes, the creature in his backyard is just a horse with a conical party hat on, but still insists that he's selling unicorns.

  I cannot understand what economic/financial role "honest" fractional reserve banking would play in a truly free market. Its instruments could not possibly trade at par with the notes of 100% reserve banks (I hope this point is obvious enough, but I wonder), so what good would they be to a borrower, who after all wishes to uses borrowed funds to acquire various means of production at prevailing prices? The whole enterprise seems absurd (and thus could only persist via fraud or state sanction).

  Published: November 2, 2008 12:42 PM

• o.jeff

  
  It seems to me, that in a free banking environment as described by Rothbard ("Mystery of Banking"), banks would likely offer the customer a choice of account types--ranging from time-based CDs (which pay the best interest), to ultra-safe segragated 100% reserve warehousing accounts (which may even charge a storage fee), to fractional reserve checking accounts which offer convenience and an opportunity to earn interest. People would split their money as their needs and risk tolerance permit.

  Published: November 2, 2008 12:59 PM

• scineram

  It is charming how legalist libertarians would condemn humanity to carrying heavy amounts of gold wherever they go instead of convenient paper money. I could not even carry enough gold to pay for a house or car with cash. We would have to replace our wallets with heavy bags.

  Published: November 2, 2008 1:35 PM

• Brent

  @ scineram:

  Thanks for your contribution. Maybe you could *try* reading some economics before you write anything else. Perhaps you could even venture into topics like money and banking!

  Published: November 2, 2008 1:59 PM

• Stanley Pinchak

  scineram,
  you could very easily carry the gold necessary to pay for a car or a house. WE are talking under 40oz for a midrange car, and under 400oz for a nice suburban house. But the entire purpose of 100% reserve banking is that checkbook money and demand deposit notes would trade at par with specie because they are entirely redeemable on demand in specie. It is not that libertarians want to force anything on anyone, they only want to eliminate fraud and inconsistencies in property rights foisted on the public from the state and special interests.

  Published: November 2, 2008 3:36 PM

• o.jeff

  Question: What would be the advice of an Austrian economist to Iceland?

  Would it be feasible for Iceland to adopt a gold standard and free banking like Rothbard describes in the Mystery of Banking (p 261, "How to Return to Sound Money")?

  How would they do this? Would Iceland have to sell some government assets (i.e. government-owned land, etc.) to buy enough gold to back the outstanding fiat money? (They have only 2 tonnes of gold according to wikipedia.)

  Published: November 2, 2008 5:00 PM

• Carlos Novais

  FRB would be impossible in a free banking system.

  1. A bank (let´s call it Bank A) with 20% reserve policy would have to inform the depositers and holders of its notes (issued as bank A notes with an explicit contract of 20% reserve policy).

  2. Notes of this bank A would never, ever be fungible with a note/deposit of another bank with 100% reserve policy.

  Ask yourself if you had 10 coins of gold in you hand you would deposit in a bank with 100% reserve or with a bank you know that only keeps 20% of its gold coins to the claims he issue (in order to give credit without having to convince depositors to engage in time deposits).

  Let´s say also that you are selling products in a shop.

  Would you sell equally at the same face value of 10 coins your products and willing to receive equally:

  10 notes/deposit of bank A or 10 notes/deposit of a bank with 100% reserve?

  
  Conclusion: what i am trying to say is that FRB is an economic impossibility if the contract implicit in the deposit and note is perfectly clear and enforced by law (=honest).

  Published: November 2, 2008 5:56 PM

• scineram

  And how would you use warehouse receipts as money? Who would pay for the storage costs?

  Published: November 2, 2008 5:59 PM

• CN

  Unit storage costs would be very low for bigger and bigger warehouses.

  Besides that, banks would still offer demand deposits in order to be able to give credit but now they would be similar with the present money -market and bonds Mutual Funds.

  Published: November 2, 2008 6:21 PM

• Carlos Novais

  Unit storage costs would be very low for bigger and bigger warehouses.

  Besides that, banks would still offer demand deposits in order to be able to give credit but now they would be similar with the present money -market and bonds Mutual Funds.

  Published: November 2, 2008 6:22 PM

• Michael Bakhama

  @scineram,

  Your assertion that libertarians would "condemn humanity to carrying heavy amounts of gold wherever they go instead of convenient paper money" is both false and absurd. You are clearly confusing paper money with fiat money. There is no libertarian objection whatsoever to using commodity-backed paper money for the sake of convenience. Our objections (both moral and economic) concern paper money that is imposed by political fiat and enforced by state coercion through, e.g., legal tender laws, taxes and regulation on ownership of precious metals, etc.

  In the future, I would suggest first understanding the libertarian position on an issue before attempting to criticize it. For starters, I would recommend "The Theory of Money and Credit" by Ludwig von Mises and "What Has Government Done to Our Money?" by Murray Rothbard.

  Published: November 2, 2008 6:44 PM

• Michael Bakhama

  I would add that I agree with those who claim that FRB is not inherently objectionable, provided there are clear contracts and full disclosure. Whether or not this arrangement could exist without state intervention is a separate question.

  Published: November 2, 2008 6:57 PM

• newson

  "FRB is not inherently objectionable, provided there are clear contracts and full disclosure. Whether or not this arrangement could exist without state intervention is a separate question."

  but disclosure to the third parties (non account holders) who are indirectly damaged by the devaluation caused through dilution of currency? how could that work?

  Published: November 2, 2008 8:30 PM

• magnus

  but disclosure to the third parties (non account holders) who are indirectly damaged by the devaluation caused through dilution of currency? how could that work?

  One way would be to require that all fractional reserve notes have the minimum fraction in reserve printed on their face. This fraction would represent the amount guaranteed to be redeemable on demand, even during the most extreme bank run situations.

  All notes, of course, are theoretically payable in full eventually, over time. The issue here is the extent to which a note would be payable on demand, even during a bank run.

  If a bank were to have excess reserves to pay a note in full, it should do so, but no bank should be permitted to deplete its reserves below the amount stated on the face of its notes.

  Maybe a 1% fractional reserve is sound. Maybe only 100% is economically justified. Maybe such fractional rates would vary depending on the economic conditions. Who knows? These fractions should be left to the market, just like everything else.

  The key issue here is disclosure. By having the minimum mandatory fraction printed on each note, people who negotiate notes for value in the economy would have the information they needed to judge for themselves the risk of holding any given note.

  Published: November 2, 2008 9:32 PM

• Mike Sproul

  Newson:

  "but disclosure to the third parties (non account holders) who are indirectly damaged by the devaluation caused through dilution of currency? how could that work?"

  It wouldn't have to work if fractional reserve banking caused no dilution of the currency. A bank that tried to back 100 checking account dollars with nothing but 10 paper dollars would be 'diluting'. A bank that backs 100 checking account dollars with 10 paper dollars plus $90 worth of other assets is not diluting. Furthermore, checking account dollars are call options on paper dollars, and call options do not dilute, or otherwise devalue, the underlying security.

  Published: November 2, 2008 9:42 PM

• Stanley Pinchak

  magnus,
  thank you for enlightening me. How does the bank know that a bank run is occurring (will occur)? How can it ensure that it will have the reserves necessary to fulfill the demand requests. If the bank were to operate normally at some percentage above the value of its notes, it may pay in full to a certain percentage of those demanding redemption. In reality, the banks would run as close to their reserves as possible so that they would make as much money as possible.

  The moment that its reserves are depleted to the minimum face value of its notes, it must immediately reject any full redemption, and only redeem at face value (until such a time as the ratio is increased). The remainder would be redeemable at some unknown point in the future. How should this future redemption be handled? Should it be first come first serve based on time of redemption request? First come first serve for initial deposit? Should the bank just fork over a portion of the title to the underlying asset? Should the bank demand that not holder come back again and again hoping to come on a good day and get the remainder of their money?

  How does the bank decide which asset is matched to which deposit account? What if an underlying asset fails to mature, the bank becomes immediately insolvent. The whole concept is ridiculous. The entire purpose of fractional reserve is to confuse the common man so that he may be more easily fleeced. Since the inflationary effects of the fractional reserve system will cause a business cycle, there will inevitably come a time where the default on the underlying assets will drive down the value of said assets to lower than book value, this will make the banks insolvent in a way which will prevent them from even maintaining their minimum face value redemption of notes. This is ultimately why fractional reserve banking is fraud. It may not be apparent until the cluster of errors fruit, but fractional reserve banking is rotten even from the very seed.

  Published: November 2, 2008 10:29 PM

• newson

  to magnus:
  stanley pinchak is right. your scheme is complicated and unworkable. in a free banking situation, each bank would select its own reserve level, and no doubt this would change over time (otherwise where would the competitive edge come in?). it would be like small print on the airline ticket explaining that life-jackets may not cover all boarders. whoever bothers to read the print or watch the safety demonstration until the plane hits the drink?

  Published: November 2, 2008 11:08 PM

• Gil

  Interesting to see your contribution on Wiki's 'fiat money' page, Mike Sproul! :)

  Published: November 2, 2008 11:26 PM

• newson

  to mike sproul:

  first, a checking-account dollar is, for all intents and purposes, the same as an ordinary dollar. not a call over an underlying security.

  second, the scenario you've described is perfectly set up to crash (think: recent melt-down). we've been down this road before, but just for auld lang syne...the problem is the overvaluation of the 90% "other assets" as well as the maturity mismatch between assets and loans. banks lend to investors who flock into hot sectors, prices are sent skywards. when the music stops, the rush to liquidate the erstwhile hot assets collapses the whole market (ie houses usa) and down go the banks.
  

  Published: November 2, 2008 11:47 PM

• Stanley Pinchak

  On a free market there is another reason why fractional reserve backed notes would not compete. One of the market's desires in a money is universal acceptance, or at least a trend thereto. If we have the case where there are 15000 banks all engaging in various levels of fractional reserve banking, then each of these levels (except for the 1:1 reserve fraction) will exchange at some discount with not only a specie dollar, but with each other as well. Since the soundness of the underlying assets at each bank would constantly cause fluctuation in the discount for each note, it would be extremely cumbersome to make exchanges in such a system. The universal acceptability of the medium of exchange breaks down, reducing therefore the willingness of the public to engage in indirect exchange with those moneys less accepted, eventually weeding out all of the fractional reserve notes. Even though fractional reserve banking has numerous other flaws, this is the deal breaker in practice.

  Published: November 3, 2008 12:14 AM

• Vanmind

  Concentrate first on achieving free market banking. Whatever happens then will answer this debate.

  Published: November 3, 2008 1:38 AM

• Arend

  "Caplan:

  You're just being difficult, Walter. If you asked a married couple "Who owns your car?" many people would say "We both own it. Fully." You can either berate them for self-contradiction, or interpret their statement charitably through the usual lens of marital property."

  Exactly, I agree. Through the lens of marital property both spouses own the car, no problem here because in marriage one can see the couple as some sort of an unitary agent in some respects. Through the lens of FRB we all own alot that other own as well, but here the marriage is unvoluntarily enforced by law. It's like a social contract one has never signed and where the conditions are constantly changed by the enforcing party.

  In the end it doesn't really matter which system is crazy or flawed (that's just economic theory and/or philosophy of science of economics), the reality is that FRB is enforced by the state which makes the banking sector is this respect (and many more I will not utter) a corporatistic sector. This in many respects cannot be defended.

  Published: November 3, 2008 4:45 AM

• CN

  The risk of FRB is that somehow the sate or bad jurisprudence enforces that notes/deposits from a bank with 20% reserve policy are fungible with notes/deposits from a bank with 100% reserve policy.

  As an excercise try to write youself what would mean a full and clear disclosure of a bank note with 20% reserve notice.

  Something like this?

  "This bank note representing the claim for 5 coins of gold is backed only by 1 coin because this bank for the sake of giving credit issues more claims that coins deposit."

  How would this note be fungible at its face/nominal value with other with 100% reserve?

  I would say that it would be pretty stuppid to accept notes/deposits at the same value from both banks.

  Even more stupid would be do deposit my coins of gold in a parcial reserve bank against notes with such an explicit contract.

  So, FRB is economically impossible.

  In really a free banking economy with explicit/clear contracts attached good money drives out bad money.

  Published: November 3, 2008 6:37 AM

• magnus

  How does the bank know that a bank run is occurring (will occur)?

  If the fraction in reserve for that note is printed on the face of the note, why does a bank need to know when a run might occur? It cannot experience a run, since it can never deplete its demand reserves below the fractional reserve amount on all of its outstanding (unredeemed) notes then in circulation.

  
  How can it ensure that it will have the reserves necessary to fulfill the demand requests?

  The same way it banks always manage reserves -- by counting the face amount of all its outstanding notes. If the fraction were printed on the face of the note, then the bank would only need to maintain reserves to cover the fraction.

  
  If the bank were to operate normally at some percentage above the value of its notes, it may pay in full to a certain percentage of those demanding redemption. In reality, the banks would run as close to their reserves as possible so that they would make as much money as possible.

  Yes, that's probably true.

  
  The moment that its reserves are depleted to the minimum face value of its notes, it must immediately reject any full redemption, and only redeem at face value (until such a time as the ratio is increased). The remainder would be redeemable at some unknown point in the future. How should this future redemption be handled?

  It could be standardized by government decree (bad), or (good) printed on the face of the note -- "Minimum 10% payable on demand, remainder payable after 10 days." Or 30 days. Or six months.

  CDs and bonds work this way -- they are payable in different percentages, with different lengths of time. Demand for different types of payment terms fluctuates like any other market commodity. That market is an important part of a money economy.

  
  Should it be first come first serve based on time of redemption request? First come first serve for initial deposit? Should the bank just fork over a portion of the title to the underlying asset? Should the bank demand that not holder come back again and again hoping to come on a good day and get the remainder of their money? How does the bank decide which asset is matched to which deposit account? What if an underlying asset fails to mature, the bank becomes immediately insolvent?

  These are the same issues confronted by every other form of business failure. There is no practice that can prevent business failure. Even 100% reserve banks can fail due to theft, embezzlement or other forms of mismanagement. Any kind of business, not just banks, can and do fail, and there are existing rules for sorting out the claims of unsecured creditors and the priority of their payment upon liquidation.

  The specific problem that is unique to fractional reserve banking is the fraud of claiming that all notes are payable on demand, when they obviously cannot be.

  Disclosure negates fraud. Here, the fraud is failing to disclose the ratio of assets in reserve as to the total obligation. If that ratio is disclosed (on the face of the note), then this particular type of fraud is avoided.

  
  The whole concept is ridiculous.

  It's not ridiculous at all. It is a form of disclosure that is uniquely tailored to the remedy (or prevent) the specific kind of fraud practiced by fractional reserve banking.

  
  If we have the case where there are 15000 banks all engaging in various levels of fractional reserve banking, then each of these levels (except for the 1:1 reserve fraction) will exchange at some discount with not only a specie dollar, but with each other as well.

  I agree entirely. Which is why I believe that requiring the fraction to be printed on the face of all notes could eventually run fractional reserve banking out of business -- the disclosure requirement would make the fractional note unattractive. Which would you rather take? A $10 note with a 10% reserve, or a $10 note with 100% reserve? Many businesses, I imagine, would refuse to take anything other than 100% reserve notes at all.

  I am a libertarian. I do not believe in total bans. I believe in remedying and preventing aggression and fraud, since they are property rights violations.

  If fractional reserve banking is a fraud (which it is), then the solution is disclosure, not rigid, blanket rules.

  Published: November 3, 2008 9:06 AM

• Stanley Pinchak

  magnus,
  I appreciate your response. If you have the time, could you address the issue related to the error cycles that manipulated interest rates produce which endanger any fractional reserve bank in a systemic way.

  Published: November 3, 2008 9:42 AM

• Mike Sproul

  Isaac:

  Your faculty parking spaces argument is stronger than you claim. A fractional reserve bank is more like a parking lot that overissues permits, but gives permit-holders the right to park in a lot down the block as well. If my fractional reserve bank runs out of cash, I still have a claim to the bank's other assets.

  Gil: Thanks. The place you should look is wiki's article on the real bills doctrine.

  Newson:

  "first, a checking-account dollar is, for all intents and purposes, the same as an ordinary dollar. not a call over an underlying security."

  Picture a call option on IBM stock with no expiration date and a strike of zero. Then try to tell me a single meaningful difference between a checking account dollar and a call option on a paper dollar.

  "the scenario you've described is perfectly set up to crash (think: recent melt-down). "

  And because it can crash you'd prohibit voluntary trade between banks and customers? The (100% reserve) bank of Amsterdam crashed too, about 1820. Might as well outlaw the Stock exchange while you're at it.
  

  Published: November 3, 2008 9:49 AM

• Mary Diane Dolan

  Economists and pundits blandly remark to one another that interest rates (rates earned on commercial bank deposits) COULD now fall to zero or less, and that inflation could fall to zero or less simultaneously. I always wonder: Under such conditions, why would anyone keep his money in a bank as opposed to another safe place? ( I am here supposing something that cannot really be supposed--i. e., that the bank would be "a safe place"). It seems to me that banks would then quietly and slowly shut down on account of simply having nothing to offer anybody. I KNOW I MUST BE WRONG because Japan has actually seen such conditions, and Japan's banks did not shut down. Can anyone explain to me how banks could stay open under the deflationary conditions described? (Bear in mind that payments can be sent in in ways not involving check-writing. Bill collectors and Western Union, for example, can transmit your cash to a recipient).

  Published: November 3, 2008 9:57 AM

• magnus

  I assume by "error cycles" you refer to the Austrian Business Cycle Theory and the malinvestment fostered by the inflationary effects of typical (i.e., fraudulent) fractional reserve banking.

  I don't see how a fully-disclosed fractional reserve note would cause the same effect as the traditional (fraudulent) one. For starters, I agree that full disclosure would completely or mostly eliminate fractional reserve notes from the cash economy. If they can't survive in a regime of full disclosure, then they shouldn't survive.

  But there is something to be gained by having some fractional reserve notes in the economy -- fractional reserve deposits would probably pay the account-holder interest, whereas 100% reserve deposits would result in less interest, zero interest, or the bank customer owing storage fees. So, from the bank depositor's perspective, fractional reserve deposits might be marginally attractive.

  The problem with fractional reserve deposits is that you get fractional notes for them, which would make them harder to pass for goods, thus less liquid. But if a depositor knew he had a ready taker of these fractional notes, or he didn't plan to spend such deposits very soon, then it might make sense to have some small part of one's assets held in fractional reserve deposits, just like people do in less-liquid savings accounts, bonds or CDs today.

  Why would the existence of fully-disclosed fractional reserve notes cause a malinvestment boom? I don't think they would. They are self-limiting in a way that ordinary (fraudulent) FRB notes are not. Fully-disclosed fractional notes would operate in the economy as a form of credit (albeit less liquid than 100% reserve notes), and credit plays an important role in economic expansion.

  Not all credit causes malinvestment. Credit is everywhere, not just from banks, but it is created whenever a merchant sells goods on pretty much any terms other than cash-and-carry.

  The boom-bust cycle arises only when credit is expanded excessively -- beyond what is economically justified by genuine demand and productivity.

  Market-based credit (as opposed to government-sponsored artificially-easy credit) is self-adjusting, just like any other kind of market adjustment for prices. If there is an economic crisis (caused by bad weather or war or some other set of negative events), then my proposed form of fully-disclosed fractional reserve notes would become even less attractive than usual, just like all forms of time-deposits become less marketable. There would be a general shift in favor of cash -- coin and 100% reserve notes.

  As I see it, conventional (fraudulent) fractional reserve notes are really just another form of time deposit, but the bank pretends that they are always redeemable on demand. This deception -- presenting time-deposits as though they are demand deposits -- is what causes the artificial expansion of credit and thus the boom-bust cycle. It makes it look like there is more money and liquidity than there really is. The fact that fully-disclosed fractional reserve notes would trade at a discount in the economy (or be refused altogether by many merchants) would help dispel this illusion of additional money.

  I should make it clear that I only offer this kind of fully-disclosed fractional reserve note in a world where paper currency is redeemable for real assets, something like gold. Nevertheless, a free and vibrant economy might make room for all kinds of hard-asset notes, like once existed in the form of silver notes. We could also witness the emergence of things like notes for oil or other commodities. Just a thought.

  My proposal makes less sense under today's Federal Reserve tyranny, where there is nothing to redeem notes for, other than more paper. The Federal Reserve was sold to the public as a way of avoiding the problem of bank runs and "panics." Fully-disclosed notes would have solved those problems. The Federal Reserve was a false solution to a mis-labled problem.

  Published: November 3, 2008 10:31 AM

• Dick Fox

  Thanks to you who commented here. I have been frustrated with Austrian economics because it has been dominated by a kook fringe that wants to impost such things as 100% banking on the rest of us. Fascism whether in a dress or in pants is still fascism. There is still hope.

  Published: November 3, 2008 11:50 AM

• Vincent Cook

  Poor Bryan. I argued with him via e-mail about business cycles and ordinality of value preferences over a decade ago, and he hasn't made much progress since then.

  Having known him from the time we were at U.C. Berkeley together, I wouldn't describe him as being an idiot, etc. He is a bright guy, and was civil in dealing with me. His problem seemed to be that he lacked the ability to critically examine the starting points of his arguments. His false analogy between joint property and fractional reserve demand claims seems to be another instance of this.

  The Rothbardian argument about fractional reserve notes and accounts is not that hard to understand. In an economic sense, demand claims function like documents of title, analogous to warehouse receipts (and bills of lading, I would add). If an instrument is to function as a money substitute, it needs the quality of negotiability, something which a transferable call loan can't provide. Rothbard correctly pointed out the inconsistency of how current laws treat money claims as opposed to warehouse claims, by falsely attempting to treat negotiable notes and accounts as loans.

  The point about negotiability (as opposed to assignment of ordinary contractual claims) may be somewhat obscure to economists who are not familiar with the legal jargon, but the idea is that redemption of a money substitute by third parties has to be perceived by the market as being free of risks, including the risk that the issuer of the substitute may come up with legal excuses (apart from the authenticity of the claim) for not paying.

  In other words, if an instrument comes attached with obligations about reserve-holding behavior by the debtor, then the transfer of the instrument has to be legally treated as an assignment, not a negotiation--invoking the privity of contract between the original creditor and the debtor to control reserve-holding behavior means that any transferee creditor must assume the risk of personal defenses against redemption of the instrument being raised by the debtor. Contractual obligations, unlike mere documents of title, are highly problematic as risk-free claims to the underlying asset.

  Lawyers restate this principle by saying that a claim, to be negotiable, has to be unconditional. The obligation of the issuer of a negotiable instrument is to be ready to deliver the specified asset when the claim matures, since the asset in fact is the property of the holder in due course of the instrument upon maturity. Pending actual delivery of the asset to its rightful owner, the relationship created by a mature negotiable instrument is necessarily a bailment.

  The odd thing about negotiable instruments that are payable on demand is that they are already mature at the time of their issuance. However, in the case of warehouse receipts and bills of lading, this hasn't prevented the legal system from recognizing the underlying bailment obligation and requiring 100% reserves against outstanding demand claims. Only in the field of money claims is this principle violated, hence the problem of fractional reserve banking.

  Published: November 3, 2008 1:04 PM

• redshirt

  A lot going on in this thread. Something that gets me about arguments for fractional reserve banking is I always thought that money is supposed to represent "real value". I go to the bank, take some money out and then go buy a donut (Dunkin of course). If things are stagnant, the change to buy that donut is the same over time.

  Same goes for the currency vs the overall economy.

  If currency flying around is "backed by collateral" and then that collateral tanks in value (houses) then we have a problem... there seems to be a disconnect in the arguments for fractional reserve banking.

  Demand drives prices. If fractional reserve banking causes the increase of available cash and drives prices up by giving the players more to play with, then it seems logical that ultimately it will implode. The big collateral asset of the day will drive the machine to generate available cash until demand drops for whatever reason. As the "collateral" backing the money above the fractional reserve dissipates the bank is left with a big problem.

  Am I missing something? Isn't that the argument against fractional reserve; that there is a disconnect from the real economy and that the amount of money out there inflates over real economic output?

  Published: November 3, 2008 3:38 PM

• newson

  mike sproul says:
  "Picture a call option on IBM stock with no expiration date and a strike of zero."

  doesn't make sense. what you've got is the fully-paid share. no expiration date makes the option valuation impossible.

  "And because it can crash you'd prohibit voluntary trade between banks and customers? The (100% reserve) bank of Amsterdam crashed too, about 1820. Might as well outlaw the Stock exchange while you're at it."

  by breaking its charter, directors of the bank of amsterdam committed fraud on its depositors. fraud will always occur; this doesn't justify its legitimization.

  the raison d'etre of the bourse is to raise equity capital. minus the monetary factors introduced via fiat money and frb, there is no reason to suppose bubbles would ever occur. crashes would be only caused by exogenous events (war, natural disaster etc).

  Published: November 3, 2008 4:10 PM

• Stanley Pinchak

  redshirt,
  You are picking on exactly the point I was trying to elucidate in my recent exchange with magnus. I don't see a way that fractional reserve banks can avoid the pitfall of creating an asset bubble by their very actions and then becoming insolvent when the public's valuations change. In your example, housing prices fall because they were run up on a wealth effect and easy credit from the fractional reserve bank.

  Mike Sproul is a proponent of real bills which if I understand correctly are limited to short term paper, but I fear that even short term paper can be backed by assets who's value may fall (being subject to malinvestment as much as long term paper is). Furthermore how can the bank ensure that the short term paper that they take is truly for short term expenses. What is to prevent a business from undertaking a long term project by writing short term notes repeatedly during the process? The value of the underlying long term asset is highly subject to changes in consumer preferences, but the notes are indistinguishable from other short term notes, e.g. payroll expenses.

  This brings us to the problem that Vincent Cook reminded us of. How can a note which for all intents and purposes purports to be negotiable be backed by an asset which is not secure. If the note is not negotiable, why would people use it for money? This is not to say that people would not use some of these techniques for investment, but there is a difference between demand deposit and investment. I agree with Vanmind, lets eliminate legal tender laws and see what the market chooses.

  Published: November 3, 2008 4:15 PM

• newson

  to dick fox:
  rothbard, block, hoppe, hulsmann, tucker etc all fascists? rather than name-calling, perhaps you'd like to offer some substantive proof as to why fraud is tolerable?
  mises' utilitarian argument that interbank redemption would limit but not eliminate monetary supply growth seems to turn a blind eye to the moral argument.

  supermarkets prosecute for petty theft even when cost/benefit analysis seems to argue against this.

  Published: November 3, 2008 4:38 PM

• newson

  to magnus:
  100% reserve banking doesn't shut off credit, it merely limits it to real savings. presumably though there would be less credit, because frb subsidizes borrowers and bankers (especially the latter) through eroding the purchasing power of those disenfranchised from the credit system.

  you still haven't eliminated the regulatory aspect by allowing partially backed notes. your scheme of disclosure would require auditing to ensure that the reserves match what is written on the notes.

  perhaps if your institution were called a "lottery" (albeit a low-payout one), and scheme participants called "punters", as opposed to "bank" and "depositors", then i'd have less of a problem. but then the odds would be constantly changing and unknowable, unlike a typical lottery. lotteries still are audited, in any case.

  
  

  Published: November 3, 2008 5:16 PM

• Brian Macker

  "If the entire banking system issues 10% more checking account dollars, and at the same time gets 10% more assets, then the money will hold its value."

  No it won't.

  Firstly, value is not intrinsic. Buying a house with one hundred ounces of gold is a subjective trade. That doesn't mean that the house is the same as one hundred ounces of gold. In the future, people in aggregate, may subjectively value it as being worth way less than that.

  Prices are ratios of convertibility. The value of money is one such ratio. What is happening when you substitute assets, say houses, for money as you claim fractional reserve banking does? The answer is that you are increasing the quantity of goods that count as money? Which effects the very ratio that is being used to value those assets.

  If gold is the money and is the numerator in the ratio, and houses is the denominator that fixes the price in gold per house. I am ignoring variability in houses which is another good reason they can’t be used as money (and a reason banks are having trouble right now assessing their balances). Say the trading ration is x gold to y houses, or x/y. Say this ratio is maintained in an environment where there are w ounces of gold and z houses.

  Now the price ratio x/y tracks the quantity of the quantity ratio w/z. If you increase the amount of gold then the ratio x/y increases, it takes more gold to buy a house. Thus x/y = c (w/z) for some constant c. Note: c may vary but not in a way that eliminates the relationship.

  Now if we are working 100% gold backed bank notes the ratio of bank notes plus circulating gold to houses is also w/z. So when you purchase the house with gold or notes you are maintaining the ratio, as you claim. That’s because it’s exactly the same as buying the house with the gold directly when banks work at 100% reserve. That is NOT true under fractional reserve.

  Now if you take notes that are suppose to be convertible into gold and start backing them with houses instead you are screwing with the very ratio that you are basing your claim on. You are converting houses into money. The w in the above equation gets substituted by m which is the amount of banknotes. People are acting as if they believe m = w, or that banknote are as good as gold.

  If the bank converts n gold into houses then the overall money to houses ratio becomes higher. There is now a quantity of money to houses ratio of (w + c)/ z which is obviously more that w/z. But since the price ration x/z depends on this it too will become larger. A larger x/z ration means that prices of houses go up.

  In short, more money chasing the same quantity of houses is causing housing prices to go up.

  So, naturally the prices of houses go up. You get asset price inflation because you are expanding the goods that are backing your money to include the houses themselves and that is self reinforcing.

  The very bad aspect of this is that the very things that are being used to expand the money supply are the things that are being first bought with the new money. The extra inflation being generated is concentrated on the very assets that are the banks are supposedly using to back their balances.

  As time progresses and prices increase the ratio of trade for banknotes to houses drops. When the bank buys assets at that point it is NOT getting assets that are at full par with the original subjective value of the gold. Each next 10% increase in the quantity of banknotes buys assets worth less and less than 10% in actual gold.

  Therefore you are wrong that the lent out gold is backed by assets that are valued at the same in gold. In fact after n gold has been lent out in this way each unit of gold at the margin is only backed by assets worth z/(w – n) gold.

  What has empirically happened in the past (and today) is that people don't realize this fraud is going on. They see the prices of the assets, say houses, rising dramatically so the take loans out to buy houses at the inflated prices.

  "If the fed expands its issue of paper money by 10%, then the fed normally gets 10% more assets in exchange, and the paper dollars will hold their value. "

  The fed just expanded the issue of base paper by 25% in two months (including banks expansion). For it's portion of the expansion it received in return a bunch of overpriced assets. The claim is that one day, wish upon a star, these assets will be performing.

  They won't. They are priced in with "c" at a very large and unsustainable value.

  Fact is that they are mostly garbage. The are based on loans given to people who will not be able to afford them if 1) The government allows the fractional reserve deflation to occur. 2) If the government doesn't allow it to occur and expands the money supply enough to compensate for the de-leveraging. That will cause inflation.

  
  These people can't meet their mortgages if they have to pay more for food, and can't do so if they start losing jobs to deflation.

  This is how the fraud is exposed. The fact that some very smart people aren't "getting it" doesn't mean the fraud isn't there. It's there alright. It's just that it's a good fraud that's likely to take suckers in.

  ” If I borrow $100,000 from a bank, and don't repay it, the bank will, in fact, become the owner of my house.”

  Remember these “assets” have little value if no one is living in them. I pointed out that the bank doesn’t really own them so that other readers would not think me a fool for conceding many points I could have made at the start of the argument. I didn’t want them interjecting to correct me for accepting your mistake. There are many reasons why treating the loans as if the bank owns the assets is foolish.

  I’ve read about real bills doctrine before and I believe it to be an economic fallacy. If after reading this post you don’t feel that you understood me and you still feel I should review it again I will do so. I don’t think it’s going to change my mind any more than re-reading Marxist doctrine would change my mind on socialism.

  BTW, one of the other reasons the real bills idea is foolish is because housing debt is very different from money. These loans are hard to assess, hard to divide, hard to transport, not fungible, etc.
  

  Published: November 3, 2008 5:59 PM

• Brian Macker

  Mike Sproul,

  I read some of your real bills stuff. I hope you didn't intent to quote yourself as an authority. Real bills is a faulty idea and expansion to include real estate backing currency is even worse.

  Read the very short book linked to with the url of my name on this comment to see what happened to France when they tried to back their currency with real estate stolen from the Catholic Church. It didn't end well.

  Published: November 3, 2008 7:06 PM

• magnus

  You are picking on exactly the point I was trying to elucidate in my recent exchange with magnus. I don't see a way that fractional reserve banks can avoid the pitfall of creating an asset bubble by their very actions and then becoming insolvent when the public's valuations change.

  I was trying to explain my position on this point when I said, "I only offer this kind of fully-disclosed fractional reserve note in a world where paper currency is redeemable for real assets, something like gold."

  What I am getting at is that the value of gold can't fluctuate, at least not in the sense of the term "value" as I am using it here. Most people today think of the term "value" as some abstract assessment of meaning or importance. But there is another, older, more concrete meaning of "value," particularly in the context of money -- it refers to the assayed weight-and-purity of a specimen of gold, such as a coin.

  I think of a "dollar" as a specific quantity of gold. (Actually, it originally referred to silver, but it works with gold, too.)

  The term "dollar" does not refer to a currency's purchasing power. It is a purely objective measurement of the quantity of a material substance. A "dollar" is, literally, a unit of physical measurement, like an inch or a gallon or a ton. In this case, it is a measurement in two parameters -- it refers to a specific weight of gold that also has a certain level of purity.

  This is the meaning of the word "value" as it is used in the Constitution, where it grants Congress the power to coin money and to "regulate the Value thereof." That's why this particular grant of federal power appears in the same sentence as the power to set standards for weights and measures.

  So, a paper banknote for 20 dollars is just that -- redeemable for 20 dollar-units of gold.

  (My position is that if this hypothetical banknote is a 10% fractional reserve note, it should say so on its face -- the bank holds a minimum of 2 dollars of gold in reserve for redemption on demand.)

  Government should not have the power to alter the measurement of a dollar any more than it should be able to decree that a New Gallon shall be 20% smaller than the usual gallon.

  The stamp certifying that a coin has a VALUE of one dollar is merely a form of product-labeling. You can't wave a magic wand and adjust the actual quantity of gold in a One-Dollar coin by calling it "20 dollars" any more than you can change the amount of wine you have by taking a standard 1.5 liter bottle and calling it 4 liters. (You can try, but you'd be a liar.)

  But that's what government has done with our money, and worse. Nowadays there aren't even any dollars at all in what they call "dollars" -- it appoints a banking cartel to oversee the grinding up of cotton and linen, pulpifies it into paper, prints magical symbols on it, and calls it a billion dollars.

  Published: November 3, 2008 8:01 PM

• scineram

  It is charming to read how frb is impossible, cannot exist, unviable, noncompetitve after centuries of evidence to the contrary at places from Venice to Canada to Sweden. Fraud yet jurists, courts, judges basically never found it that way.

  Published: November 3, 2008 8:04 PM

• Brian Macker

  Scineram,

  No one said it was impossible. Ponzi schemes are perfectly possible too. They are just not a good way to run an economy if you want to avoid economic recessions, depressions, crisis, and meltdowns.

  I bet you find it charming when people talk about the bad aspects of communism too.

  Published: November 3, 2008 8:31 PM

• magnus

  Fraud yet jurists, courts, judges basically never found it that way.

  Logic apparently has no sway over you, but you should at least consider the fact that slavery was considered legal for far longer than it has been deemed illegal.

  Published: November 3, 2008 8:35 PM

• redshirt

  Sorry Stanley... my bad. No picking intended. I was mostly thinking aloud in the blog and it probably landed on your ears.

  Excellent comments.

  Regards,

  -r

  Published: November 3, 2008 9:01 PM

• Stanley Pinchak

  scineram,
  if you have 42 minutes, I recommend that you watch the recently posted Rothbard video from 1983. He goes over some of the history of fractional reserve banking in the Colonies and United States. Also enlightening is de Soto's, "Money, Bank Credit, and Economic Cycles." He covers sound banking and fractional reserve banking and notes that jurists were handing down judgments against fractional reserve banking even into the 20th century. There is more to fractional reserve banking than is perceived at first glance.

  Published: November 3, 2008 9:23 PM

• jp

  If I was a shopkeeper in a free world, I would accept 100% gold backed notes and FRB notes (redeemable for gold) at the same rate for my goods.

  The problem with 100% notes is I'd immediately be responsible for paying storage fees for the gold back at the bank. No one likes fees. Not knowing if the previous note holders had paid their fees, I could be on the hook for their unpaid storage balances were I to redeem them for gold. No shopkeeper likes those odds.

  FRB notes have the uncomfortable aspect of being a claim on gold that may not be accessible in the case of a bank run, but at least I don't have to pay storage fees. I'd probably only accept the FRB notes of the most reputable banks just to cut down on my risk.

  So I'll take a bit of both, balancing my proportions according to my appetite for risk and ability to pay fees. And shame on the dictator who would prevent me from either. Cheers!

  Published: November 3, 2008 10:07 PM

• Peter

  One way would be to require that all fractional reserve notes have the minimum fraction in reserve printed on their face. This fraction would represent the amount guaranteed to be redeemable on demand, even during the most extreme bank run situations.

  That wouldn't work - if they keep, say, 10% reserves, they could in theory pay out 10% to every claimant, but that won't happen in reality - they'll pay out 100% to first claimants, and nothing to those who turn up too late. If they're going to print the amount that's guaranteed to be redeemable on the notes, the only value they could print without lying would be "zero".

  Published: November 3, 2008 10:17 PM

• newson

  magnus says:
  "So, a paper banknote for 20 dollars is just that -- redeemable for 20 dollar-units of gold.
  (My position is that if this hypothetical banknote is a 10% fractional reserve note, it should say so on its face -- the bank holds a minimum of 2 dollars of gold in reserve for redemption on demand.)"

  but what sort of contract has the note holder really got with the issuer? let's imagine a run situation. whether a note holder gets full, partial or zero conversion on his frb notes is entirely unpredictable. maybe if he's early, he gets partial satisfaction, if he's well-connected, full payment in gold, and if he's a late nobody, well, zero. de soto call this an aleatory contract.

  
  who would be auditing the books of the bank to ensure that the backing rules are adhered to?

  Published: November 3, 2008 10:30 PM

• newson

  to jp:
  and what about the third party, who neither borrows nor has bank accounts, but whose purchasing power is eroded by your frb transactions as they percolate through the economy?

  are you not a passive player, and limited beneficiary in a pickpocketing? why is this not aggression?

  Published: November 3, 2008 10:46 PM

• jp

  "and what about the third party, who neither borrows nor has bank accounts, but whose purchasing power is eroded by your frb transactions as they percolate through the economy?"

  In a free world, the 3rd party you mention is satisfied. If you think it inevitable the erosion of the purchasing power of all brands of FRB notes, you'd be free to accumulate cash in the form of gold. If circumstances prove you right, you'll still have the ability to buy things while FRB holders will have lost all. Until that happens, you'll have to get used to a bunch of clanking metal in your pockets, or the fees required at a gold storage warehouse.

  Again, the important point is having the ability to pick whatever form of money you think best, whether that be gold, FRB notes, or 100% notes. Pick your poison.

  Published: November 3, 2008 11:57 PM

• Carlos Novais

  jp says: "If I was a shopkeeper in a free world, I would accept 100% gold backed notes and FRB notes (redeemable for gold) at the same rate for my goods."

  Well jp, i will to ask you to deposit your life savings of let´s say 100 coins of gold in my FRB (10% reserves) agains a receipt saying:

  "This is a claim on 100 gold coins taken that this bank will issue additionally 9 times similar claims for the sake of giving credit - good to my business - meaning that you will share a claim of 100 coins with others 900 similar claims on demand...good luck!"

  As i previously posted, no way people would deposit physical coins in such banks and no way a shopkeeper would accept equally 100 coins of gold (or receipts from a 100% reserve bank) or 100 receipts of a 10% FRB.

  If that would be the case, FRBs would be able to simply buyout agressively 100% reserve banks in the stock market just issuing such claims (let´s say creating 10 times banking notes to the actual coins) because stockholders would accept to be paid with such receipts at its face value.

  Published: November 4, 2008 2:43 AM

• o.jeff

  To Brian Macker: Thank you for recommending the book "Fiat Money Inflation in France." (Available on Mises.org in PDF) This was a fantastic and eye-opening little book for me. The parallels to our modern day economy are economic situation were sobering and frightening!

  Published: November 4, 2008 7:24 AM

• newson

  to jp: to the extent that frb is widespread, everyone is forced to become an asset-trader to save purchasing power (like today, except no tax), but that still leaves us with the business cycle. remember much of marx's firepower came from the periodic collapses that were an supposedly an integral part of capitalism.

  historically, where has free banking ever worked? the inherent flaws inevitably come to the surface, the run comes and the bankers get a political fix at the expense of either account-holders or the general public.

  why should the next time will be different? the central bank exacerbates the problem, but doesn't ultimately originate them, they come from the model's non-viability. failure only attracts the "helping hand" of government.

  liberalized banking with 100% reserving kills the business cycle, and is immune to the bank run. people are free to invest in whatever harebrain schemes they chose, but that it not be called money, and the issuer not be called a bank, and that participants not be called depositors.

  a gallon is not less than a gallon if there is some fine-print exclusion clause. language twisted willfully is tantamount to deception or fraud.

  Published: November 4, 2008 8:08 AM

• magnus

  but what sort of contract has the note holder really got with the issuer? let's imagine a run situation.

  The third party has no contract. But he doesn't need one.

  I propose that FRB should be permitted only if:

  (a) there is a real asset that will be held in reserve, for which the note may be redeemed, and the form of this asset is disclosed on the note, like a gold note, or a silver note (or whatever), and

  (b) the minimum fraction of that asset to be held in reserve (and therefore guaranteed to be paid on demand) is printed on the face of every note.

  I believe this is necessary to prevent fraud to third parties -- people other than the bank's own customers who receive that bank's notes in commerce. There is no need for any contract between these third parties and the bank. Even without a contract, the bank owes everyone a duty not to defraud them. By claiming to redeem all notes on demand, when a fractional reserve bank clearly cannot do so, fractional reserve banks engage in an age-old fraud.

  If people (both customers and third parties) want to accept the risk of accepting fractional reserve notes as payment, then they should be allowed to do so. But passing a risk onto someone without disclosing the true extent of that risk is unacceptable in a free society.

  
  whether a note holder gets full, partial or zero conversion on his frb notes is entirely unpredictable. maybe if he's early, he gets partial satisfaction, if he's well-connected, full payment in gold, and if he's a late nobody, well, zero.

  This is true for all fractional reserve banking whether my proposed disclaimer about the extent of actual reserves is printed on the face of the note or not.

  I fully acknowledge that my proposed disclaimer does not eliminate the risk that a fractional reserve bank may default on redeeming the full value of some or all of its FRB notes. My proposed disclaimer doesn't make that risk any worse, but it does alleviate the problem of the note-holders not knowing how much (or how little) is guaranteed to be in reserve. (Of course, a bank could deplete its reserves below the stated minimum for its outstanding notes, in which case it has committed an even clearer type of fraud, or an outright embezzlement.)

  
  who would be auditing the books of the bank to ensure that the backing rules are adhered to?

  This is a secondary issue. It should really be separated from your opinion on the issue of whether the minimum fraction should be printed on the face of FRB notes, or whether FRB should be allowed under any circumstances.

  In any event, I suppose the answer depends on whether you are a minarchist or an anarchist. A minarchist would permit a government to perform that function -- performing audits, spot-checks, and prosecuting bankers who fail to redeem even the minimum fraction stated on the face of their notes due to insufficient reserves.

  An anarchist would say that this function would be performed by private auditors, or by a bank's voluntary disclosure of its reserves in an effort to foster consumer confidence.

  Published: November 4, 2008 9:40 AM

• Stanley Pinchak

  jp brings up an interesting point. 100% reserve notes would most likely have to have their upkeep paid at the time of issuance. So a bank would have to estimate a fully amortized cost of maintaining the note's gold in their vaults, and charge this up front at issuance. If the upkeep were not paid in advance, any notes suffering from this would necessarily trade at a discount to specie, reducing their effectiveness as a money. I believe that in this case, checkbook money may be more feasible than demand deposit notes. In either of these cases the upkeep is not a surprise (check book account), or not relevant (fully paid note) when the third party note bearer goes to redeem his instrument. The only problem that I see with this is the possibility of upkeep being multiply applied to the same physical units of gold. Keeping this straight may prevent the adoption of even fully backed notes.

  Published: November 4, 2008 11:14 AM

• jp

  "Well jp, i will to ask you to deposit your life savings of let´s say 100 coins of gold in my FRB "

  Sorry but I'd never take your FRB notes. The Bank of Carlos Novais has no reputation, history, or expertise in the matter. As I said, I'd only accept the notes of reputable and large banks with conservative lending practices and a well diversified deposit base.

  "people are free to invest in whatever harebrain schemes they chose, but that it not be called money, and the issuer not be called a bank, and that participants not be called depositors."

  No problem. If this is just about semantics, in a free world we'll just call them FRB notes, not money. The issuer will call itself an FR banc, not a bank. And as a participant I'll be called a lender, not a depositor. With the words changed will you still try to prevent me from accepting FR banc notes instead of 100% backed notes or gold for my goods?

  Published: November 4, 2008 11:20 AM

• newson

  to jp:
  i think semantics are extremely important in business, so as people are not deceived as to what the real nature of the product is.

  "banc" sounds like "bank", why don't you call your company "corp"? maybe you're sneakily trying to get people to believe their money is safe, as rightfully most people believe when they "deposit", or entrust their current account money for safe-keeping. call your bits of paper "fr notes", and your company "corp" or "scheme" or whatever, but not "bank" "banc" or other homonym. (contracts can be verbal, too, so sounds count).

  i don't have to vet my wheat purchases to see whether i've been sold "weet" (something else whose ingredients may or may not include what i thought i was buying). in the same way, "deposit" has a clear meaning that should not be twisted. same goes for "loan", and "gift" etc.

  likewise, if i walk into a doctor's surgery, i expect not to be checked out by a vet, or by a doctor of letters.

  in all probability, were there no regulatory regime for deposit-taking banks, "bancs" would face legal action from banks, who would be alarmed at this sleight of hand.

  Published: November 4, 2008 5:02 PM

• Brian Macker

  o. Jeff,

  You are welcome. Murray Rothbard's book "The Panic of 1819" might also be of interest to you. It's also available online here at mises.org using the link of my name on this comment. It's about 2.5 times longer a book.

  That instance of credit expansion around 1819 had much more private self dealing involved. You won't believe what the bankers got away with.

  Published: November 4, 2008 6:45 PM

• Mike Sproul

  Brian Macker:
  "Read the very short book linked to with the url of my name on this comment to see what happened to France when they tried to back their currency with real estate stolen from the Catholic Church. It didn't end well."

  The episode went exactly as the real bills doctrine said it would. When the assignats were adequately backed (by the land, etc) they held their value. When the land had been sold off, and the National Assembly kept issuing floods of paper currency without getting adequate backing in exchange, the assignats lost value.

  The RBD says that the value of money is equal to the value of the assets backing it. If a 10% increase in money is matched by a 10% increase in the assets of the issuing institution, there will be no inflation. If money outruns assets, there will be inflation.

  Stanley Pinchak:
  "Mike Sproul is a proponent of real bills which if I understand correctly are limited to short term paper, but I fear that even short term paper can be backed by assets who's value may fall"

  The RBD has been around for centuries, and has been stated in many different ways. The version I advocate says that the value of money is equal to the value of the assets backing it. Short or long term is irrelevant. Only value matters, and of course is those assets lose value, the money will too, just like any other financial security.

  Newson:

  ""Picture a call option on IBM stock with no expiration date and a strike of zero."

  doesn't make sense. what you've got is the fully-paid share. no expiration date makes the option valuation impossible. "

  No expiration date makes valuation trivial. A call on IBM with a zero strike and no expiration date will always be worth exactly the same as one share of IBM, just as a checking account dollar is always worth one green paper dollar.

  Published: November 4, 2008 8:49 PM

• Peter

  As I said, I'd only accept the notes of reputable and large banks

  Something like Lehman Brothers, y'mean? :)

  Published: November 5, 2008 12:41 AM

• Carlos Novais

  jp: "Sorry but I'd never take your FRB notes. The Bank of Carlos Novais has no reputation, history, or expertise in the matter. As I said, I'd only accept the notes of reputable and large banks with conservative lending practices and a well diversified deposit base."

  That do not explanain why a FRB would be able to issue notes with a contract taht have an implicit credit risk plus the uncertainty of how much more the fractional ratio will be (even if hte contract is clear and says a minimum of 20%)...

  ... and those notes will be accepted at its face value agains a 100% reserve bank.

  Seems to be that i would personally sell short every FRB receipts (i would take a line of credit ) at its face value against jp (jp would buy it, or se he says...) and buy 100% FRB notes.

  Published: November 5, 2008 3:11 AM

• scineram

  But what are these 100% backed notes? Where and when did these existed and used as money widely?

  Published: November 5, 2008 8:30 AM

• Carlos Novais

  ... i would personally sell short every FRB receipts (i would take a line of credit at a FRB established in the market ) at its face value against jp (jp would buy it, or so he says...) and buy 100% RB notes (jp would sell it).

  Published: November 5, 2008 8:58 AM