Cross posted at Mises.org and The Coordination Problem.
Come the Revolution, in a free banking world, where there is at least no lender of last resort, commodity backed money with no possibility of over issuing above that commodity in reserve and no deposit insurance, it would be possible for safe deposit accounts and savings accounts where money is lent to borrowers to exist. Both 100% Reserve Free Bankers and Fractional Reserve Free Bankers would be happy thus far. If an instant access demand deposit is offered that is fractional in nature, we get heated debate within the free banking community; the arguments will be familiar to readers of this site. So I am going to throw in a left field ball and see what comes out in debate about what I see as a potential solution to this. I will remain silent on the thread until all comments are in.
The Third Type of Account (not named yet, will not use 100% or Fractional in the title due to fear of the verbal abuse that will come forth!)
Consider this, a depositor goes into his bank, he is offered a safe deposit account that is safe, but gives no interest, his time preference is such that he wants to earn some interest. The bank worker shows him to his colleague who offers him a savings account. Our depositor loves the rate of interest offered, but notes that he has to put his money away for at least a month, 3,6,9, 18 months, X number of years to get a proceedingly better rate of interest. This does not satisfy our depositor as he wants to have instant access and interest. He wants to have his cake and eat it. He gets taken to see the Third Type of Account manager. This manager says this account is a timed deposit account in nature i.e. your money is locked away for at least a month, 3,6,9 18 months X number of years, but the bank will allow instant access, by exception for the liquidity that it keeps in reserve all the time. However, should there be too much call on liquidity, the bank reserves the right to point out that you the depositor are actually a de jure timed depositor / creditor to the bank for at least a month, 3,6,9 18 months X number of years and are going to he held to the time period you freely signed up to.
This third type of account always allows the bank to be reliant on no legal privilege and no accounting standard that is different to other commercial organisation to keep its current and long term creditors whole at all points in time as the creditor in question is in fact a timed depositor who has instant liquidity by exception and not by demand. The reality is this liquidity would be almost at all times there bar the period of bank runs. In fact, dare I say it (I can feel the avalanche of invective building up already) that this is a robust 100% reserve type account form an accounting an legal point of view, with all the benefits of a fractional reserve account of instant access, with none of the inflationary business cycle inducing consequences hotly alleged by the 100% Reserve Bankers.
Toby,
I see clearly how this could work. It is really like a callable bond with perhaps some conditions attached. It would satisfy depositors who both want interest and to be able to call the balance on demand. The bank could either keep reserves on hand or have a specific line of credit for this purpose. Alternatively, it could buy the bond back off you and immediately turn around and sell it in the secondary market. There would be a fee based on how quickly you wanted your money (instantly, in a few hours or in a few days).
This is perfectly compatible with 100% reserves as the bond would only be redeemed when there was cash available to do so. However, I suspect the Free Bankers would not be happy as they are all closet inflationists!
Robert Sandler,
Why shouldn’t banks keep cash on hand to pay such bonds at all times? If they do that then how is it very different from a fractional-reserve bank account?
Current,
This would be a separate operation from money warehousing. A customer’s demand deposit would be 100% backed.
I called it (no pun intended) a callable bond but it would actually be a putable bond. Conditions would be attached such that the bank would only endeavor to make its best efforts to pay on demand but would not guarantee it. Not having cash available at the instant the customer demands it would not be an event of default and the customer would be fully aware of this.
The main point is that the there would be no confusion on the customer’s part about whether he had title to the money at the bank or not. He would either have a 100% guaranteed demand deposit or a bond and he would be under no illusions about which.
> I called it (no pun intended) a callable bond but it would actually
> be a putable bond. Conditions would be attached such that the bank
> would only endeavor to make its best efforts to pay on demand but
> would not guarantee it. Not having cash available at the instant
> the customer demands it would not be an event of default and the
> customer would be fully aware of this.
Yes, I understand that. However, what’s to stop a bank from always redeeming when asked, and building a reputation for doing so? In that case the how would they be doing anything economically different from creating fractional reserve current accounts? I agree that they would be legally different but how would that legal difference affect economic calculation in any significant way?
> The main point is that the there would be no confusion on the
> customer’s part about whether he had title to the money at the bank
> or not. He would either have a 100% guaranteed demand deposit or a
> bond and he would be under no illusions about which.
Yes, but such an aim would be satisfied by the bank clearly declaring to it’s customers that it’s notes and current accounts are debts.
Current,
>Yes, I understand that. However, what’s to stop a bank from always redeeming when >asked, and building a reputation for doing so?
I don’t see the problem if they always redeem when asked. Do you mean if they guaranteed (or implied a guarantee) to always redeem when actually they cannot?
>In that case the how would they be doing anything economically different from creating >fractional reserve current accounts? I agree that they would be legally different but how >would that legal difference affect economic calculation in any significant way?
The crucial difference is that there would be no pyramiding of deposits. Person A makes a fixed term 12 month putable loan (i.e. buys the bond) to the Bank. There is no need for the Bank to keep a persistent reserve because ownership of the cash has been passed to the Bank. The Bank lends all of this cash in a 12 month term loan to Person B. B now owns the cash and he deposits it in his account at the Bank. The process halts here because the Bank must keep 100% reserves for the deposit (and the deposit is owned by B). There is no money creation here and therefore no inflation. All that has happened is a flow of the same amount of funds from A to B via the Bank.
If A puts the loan (bond) back to the Bank then this issue is resolved in one of several ways:
-If B repaid the loan early the Bank uses those funds to repay A
-The Bank legally denies A’s request (not a breach of contract)
-Or we expand the example and the Bank sells a new bond to someone else for the remaining term of B’s loan and uses those funds to repay A
In short, there is no inflation, no bank run risk and the risk of insolvency is sharply reduced. The primary risk of the Bank and Person A is credit risk.
>Yes, but such an aim would be satisfied by the bank clearly declaring to it’s customers >that it’s notes and current accounts are debts.
True. Why do you think they don’t do that?
> Current,
>> Yes, I understand that. However, what’s to stop a bank from always
>> redeeming when >asked, and building a reputation for doing so?
>
> I don’t see the problem if they always redeem when asked. Do you
> mean if they guaranteed (or implied a guarantee) to always redeem
> when actually they cannot?
I don’t see any problem with banks guaranteeing to always redeem. As I said in the long discussion with Stephen contracts are never zero risk. Whether a debt contract has been fulfilled or not depends on the practical circumstances, not a theoretical analysis of what happens when every debt holder demands redemption at the same time.
>> In that case the how would they be doing anything economically
>> different from creating fractional reserve current accounts? I
>> agree that they would be legally different but how would that legal
>> difference affect economic calculation in any significant way?
>
> The crucial difference is that there would be no pyramiding of
> deposits. Person A makes a fixed term 12 month putable loan
> (i.e. buys the bond) to the Bank. There is no need for the Bank to
> keep a persistent reserve because ownership of the cash has been
> passed to the Bank.
Yes, but the bank can keep a persistent reserve. Note that the possession of the cash always passes to the bank in our current system.
> The Bank lends all of this cash in a 12 month term loan to Person
> B. B now owns the cash and he deposits it in his account at the
> Bank. The process halts here because the Bank must keep 100%
> reserves for the deposit (and the deposit is owned by B). There is
> no money creation here and therefore no inflation. All that has
> happened is a flow of the same amount of funds from A to B via the
> Bank.
But, what happens if Person B uses the same kind of account as person A does. What happens if he makes a 12 month “putable loan” to another bank?
> If A puts the loan (bond) back to the Bank then this issue is
> resolved in one of several ways:
>
> -If B repaid the loan early the Bank uses those funds to repay A
The bank doesn’t have to match up lending and borrowing in that way. What the bank does is it tracks the behaviour of it’s lenders and it’s borrowers. It then estimates what actions it needs to take to make a profit and stay solvent.
Your current account isn’t matched with anyone elses, it goes into a general pool. As you say later:
> -Or we expand the example and the Bank sells a new bond to someone
> else for the remaining term of B’s loan and uses those funds to
> repay A
> -The Bank legally denies A’s request (not a breach of contract)
Yes, but if the bank does that then it will lose reputation. Just as a tomato grower may never gaurantee high quality tomatoes, but may actually always produce them. If that grower reduces his quality then he will lose the reputation that his previous behaviour ensured.
> In short, there is no inflation,
Why not? If people decide to treat the “putable loans” like they do bank accounts now then they become a money substitute.
I actually agree that there wouldn’t be inflation, but I’d derive that theory from the fractional-reserve free-banking school’s theories.
But, how can 100% reserve proponents argue that there would be no inflation?
> no bank run risk
I don’t think the risk of bank bankruptcies has changed at all. Throughout history the bankruptcies of banks have been caused by them making bad loans. If the market hears that a bank has made bad loans to the extent that it is insolvent then a run occurs.
In the situation you describe, if a bank become bankrupt by making bad loans then it will still be bankrupt. It may be able to say to it’s savers “we will pay you in one year as agreed”, but if it’s bankrupt then those savers will not accept such terms. They will sue the bank and it will enter receivership.
The only possible scenario where the system you describe may help is if the bank gets an unusually large number of redemptions at the same time. But, this never happens by chance. Any bank that keeps a reasonable quantity of reserves can pay for redemptions. Even if a bank doesn’t do that then any solvent bank can normally sell assets to other banks in exchange for base money and service it’s redemptions that way. As David Hillary mentioned elsewhere a study by the bank of international settlements couldn’t find any historical instance of a bank failure caused by liquidity mismanagement.
> the risk of insolvency is sharply reduced. The primary risk of the
> Bank and Person A is credit risk.
I don’t think the risk is reduced much at all. Credit risk is always the significant risk.
>> Yes, but such an aim would be satisfied by the bank clearly
>> declaring to it’s customers >that it’s notes and current accounts
>> are debts.
>
> True. Why do you think they don’t do that?
In many places they do. Though it’s quite true that the wording of modern British banking contracts is vague. I don’t think that bank rely on this though, in many other places and many historical times it has been well known that banks are fractionally-reserved and customers have chosen them anyway. I support changing the law to ensure that banks are clearer in Britain, I don’t think that such a change would alter the market much though.
Current, thanks for coming back, I appreciate it.
“I don’t see any problem with banks guaranteeing to always redeem. As I said in the long discussion with Stephen contracts are never zero risk. Whether a debt contract has been fulfilled or not depends on the practical circumstances, not a theoretical analysis of what happens when every debt holder demands redemption at the same time.”
This works only if it is accepted and clear that the customer is a debt holder. However, to call a demand deposit a debt is, in my view, a contradiction in terms.
“Yes, but the bank can keep a persistent reserve. Note that the possession of the cash always passes to the bank in our current system.”
Whether the Bank keeps a persistent reserve is not the key point here. The key point is that there is no pyramiding of deposits.
“But, what happens if Person B uses the same kind of account as person A does. What happens if he makes a 12 month “putable loan” to another bank?”
Good question.
There is still no inflation. The key here is that along each link in the chain the funds are only exclusively available to one person at a time. Eventually, these funds will make their way to someone’s deposit account and that will be the only deposit account pertaining to these funds.
In FRB you could have more than a hundred people (depending on the RR) having access to the same funds. Assume an initial deposit of £5000 and a RR of 1%. Each would show a deposit balance of £5000 coming to a total in demand deposits of £500,000. A massive increase in “money” here. According, to my example you have several loans but only one deposit balance of £5000. The bonds (loans) cannot be used as money.
“The bank doesn’t have to match up lending and borrowing in that way. What the bank does is it tracks the behaviour of it’s lenders and it’s borrowers. It then estimates what actions it needs to take to make a profit and stay solvent.”
That’s how FRB (tries) to work but not how the Bank works in my example. A prudent bank would match up the duration of its assets and liabilities. Btw where there is estimation there is error. Eventually, an FRB will make a critical error. If it can happen it will happen.
“Yes, but if the bank does that then it will lose reputation.”
There are reputational issues but that is not a factor in how the putable bond system differs from FRB.
“Why not? If people decide to treat the “putable loans” like they do bank accounts now then they become a money substitute.
But, how can 100% reserve proponents argue that there would be no inflation?”
Because the putable bonds will not be a money substitute. Putable bonds exist in the marketplace now and I have yet to hear of anyone using them as money. Arguably you could trade the value of your putable bond to someone for a good or service (or sell it for money) but the receiver would not confuse this risky bond for money.
“I don’t think the risk of bank bankruptcies has changed at all. Throughout history the bankruptcies of banks have been caused by them making bad loans. If the market hears that a bank has made bad loans to the extent that it is insolvent then a run occurs.
The only possible scenario where the system you describe may help is if the bank gets an unusually large number of redemptions at the same time. But, this never happens by chance. Any bank that keeps a reasonable quantity of reserves can pay for redemptions. Even if a bank doesn’t do that then any solvent bank can normally sell assets to other banks in exchange for base money and service it’s redemptions that way. As David Hillary mentioned elsewhere a study by the bank of international settlements couldn’t find any historical instance of a bank failure caused by liquidity mismanagement.”
Both you and David keep mentioning this BIS study. If it is the study I am thinking of (Bank Failures in Mature Economies, April 2004) it does not set out or prove what the two of you suggest it does. It’s a general study of recent bank failures that covers about 30 years of banking. Banking has been around for 5000 years. In fact, I think the study is a severe indictment of FRB in general. I would not recommend anyone use it to defend FRB.
If we can demonstrate a priori that bank runs absolutely can occur without a single bad loan having been made then we know that they absolutely will. In fact, historically banks have failed when too many depositors showed up at once and this did not require bad loans.
You may wish to question why bad loans are made in the first place. As we know, a key facet of the Business Cycle is the preponderance of poor investment decisions, all revealed to be poor at the same time. It is no accident that FRB banks make lots of bad loans. FRB leads to inflation, which lowers interest rates which causes malinvestments (read: bad loans) which lead to business and banking failures.
“I don’t think the risk is reduced much at all. Credit risk is always the significant risk.”
Under FRB there is massive insolvency risk. This magnifies the credit risk. With my scenario there is zero financial risk to the depositor.
“I support changing the law to ensure that banks are clearer in Britain, I don’t think that such a change would alter the market much though.”
Just my opinion but I suspect banks would strongly resist that. So would the government as they benefit strongly from the current system. I also think that if people realized just how much risk they were taking with FRB they would either demand a significantly higher interest rate (rather than the negative rates they get now) or would not put their money in FRB banks. Either would spell the end of FRB.
Just errata on the following:
>In FRB you could have more than a >hundred people (depending on the RR) >having access to the same funds. >Assume an initial deposit of £5000 >and a RR of 1%. Each would show a >deposit balance of £5000 coming to a >total in demand deposits of £500,000.
Each subsequent deposit balance would be slightly less than the former, i.e. £5000, then £4950 then £4900.50 and so on. Leading to more than a 100 people as well.
Robert Sadler,
> Current, thanks for coming back, I appreciate it.
>
>> I don’t see any problem with banks guaranteeing to always
>> redeem. As I said in the long discussion with Stephen contracts are
>> never zero risk. Whether a debt contract has been fulfilled or not
>> depends on the practical circumstances, not a theoretical analysis
>> of what happens when every debt holder demands redemption at the
>> same time.
>
> This works only if it is accepted and clear that the customer is a
> debt holder. However, to call a demand deposit a debt is, in my
> view, a contradiction in terms.
I agree that the term “deposit” is confusing. I wouldn’t mind if the law were changed to ban the use of that word in connection with bank accounts. “Current account” is a better term.
However, in terms of banking “deposit” has meant debt since the 17th century.
>> Yes, but the bank can keep a persistent reserve. Note that the
>> possession of the cash always passes to the bank in our current
>> system.
>
> Whether the Bank keeps a persistent reserve is not the key point
> here. The key point is that there is no pyramiding of deposits.
>
>> But, what happens if Person B uses the same kind of account as
>> person A does. What happens if he makes a 12 month “putable loan”
>> to another bank?
>
> Good question.
>
> There is still no inflation. The key here is that along each link in
> the chain the funds are only exclusively available to one person at
> a time. Eventually, these funds will make their way to someone’s
> deposit account and that will be the only deposit account pertaining
> to these funds.
The reason that we say that banking increases the quantity of money is because current account balances and banknotes are money substitutes. A current account balance is not the same thing as money, but the point is that it behaves in the same way, so from an economic point of view it must be categorised alongside money.
The problem with your argument here is that it’s not only the final deposit account that is money. Money is defined by the market not by abstract argument. If people decide to treat balances in “putable loan” accounts as money then they will become a money-substitute. Abstract argument about what underlies those accounts can’t change that.
> In FRB you could have more than a hundred people (depending on the
> RR) having access to the same funds. Assume an initial deposit of
> £5000 and a RR of 1%. Each would show a deposit balance of £5000
> coming to a total in demand deposits of £500,000. A massive increase
> in “money” here. According, to my example you have several loans but
> only one deposit balance of £5000. The bonds (loans) cannot be used
> as money.
Why can’t they be used as money? You haven’t really given a reason.
>> The bank doesn’t have to match up lending and borrowing in that
>> way. What the bank does is it tracks the behaviour of it’s lenders
>> and it’s borrowers. It then estimates what actions it needs to take
>> to make a profit and stay solvent.
>
> That’s how FRB (tries) to work but not how the Bank works in my
> example. A prudent bank would match up the duration of its assets
> and liabilities.
No it won’t, banks have never done this. Certainly there is some risk
in mismatching assets, but not enough to prevent it being worthwhile.
Or, are you proposing that banks be banned from maturity transformation?
> Btw where there is estimation there is
> error. Eventually, an FRB will make a critical error. If it can
> happen it will happen.
*Every business* relies on estimation. I expect some time in the future a bank may go bankrupt by misestimating the amount of reserves it requires. But, just because a risk exists doesn’t mean that a business must do everything it can to prevent it from occurring.
Someone could say…. A bank that keeps accounts in gold may get robbed. It must estimate the security procedures that it must take. But, where there is estimation there is error. Eventually, a 100% reserve bank will make a critical error. If it can happen it will happen.
Certainly it’s true that mistakes will occur. But, all contracts involve some degree of risk even if it’s very small. It’s down to the parties involved to decide how much of it they will take.
>> Yes, but if the bank does that then it will lose reputation.
>
> There are reputational issues but that is not a factor in how the
> putable bond system differs from FRB.
I agree about that.
>> Why not? If people decide to treat the “putable loans” like they do
>> bank accounts now then they become a money substitute.
>>
>> But, how can 100% reserve proponents argue that there would be no
>> inflation?”
>
> Because the putable bonds will not be a money substitute. Putable
> bonds exist in the marketplace now and I have yet to hear of anyone
> using them as money.
Yes, a present we have fractional reserve banking, it’s legal. What we’re arguing about is the situation that would prevail if it’s made illegal.
> Arguably you could trade the value of your putable bond to someone
> for a good or service (or sell it for money) but the receiver would
> not confuse this risky bond for money.
That’s only your opinion though. It’s up to those actually making the exchange to decide what they think about the risk.
>> I don’t think the risk of bank bankruptcies has changed at
>> all. Throughout history the bankruptcies of banks have been caused
>> by them making bad loans. If the market hears that a bank has
>> made bad loans to the extent that it is insolvent then a run
>> occurs.
>>
>> The only possible scenario where the system you describe may help
>> is if the bank gets an unusually large number of redemptions at the
>> same time. But, this never happens by chance. Any bank that keeps a
>> reasonable quantity of reserves can pay for redemptions. Even if a
>> bank doesn’t do that then any solvent bank can normally sell assets
>> to other banks in exchange for base money and service it’s
>> redemptions that way. As David Hillary mentioned elsewhere a study
>> by the bank of international settlements couldn’t find any
>> historical instance of a bank failure caused by liquidity
>> mismanagement.”
>
> Both you and David keep mentioning this BIS study. If it is the
> study I am thinking of (Bank Failures in Mature Economies, April
> 2004) it does not set out or prove what the two of you suggest it
> does. It’s a general study of recent bank failures that covers about
> 30 years of banking. Banking has been around for 5000 years. In
> fact, I think the study is a severe indictment of FRB in general. I
> would not recommend anyone use it to defend FRB.
Let me put it like this: how many examples can you provide an example of banks that failed because it didn’t have enough reserves to service redemptions?
> If we can demonstrate a priori that bank runs absolutely can occur
> without a single bad loan having been made then we know that they
> absolutely will.
Oh, I agree entirely that it can concievably happen. But, account holders are hardly going to concern themselves with that, the issue is the risk of it happening.
> In fact, historically banks have failed when too
> many depositors showed up at once and this did not require bad
> loans.
Ok, give some examples.
> You may wish to question why bad loans are made in the first
> place. As we know, a key facet of the Business Cycle is the
> preponderance of poor investment decisions, all revealed to be poor
> at the same time. It is no accident that FRB banks make lots of bad
> loans. FRB leads to inflation, which lowers interest rates which
> causes malinvestments (read: bad loans) which lead to business and
> banking failures.
I agree that over time banks find ways to minimize the amount of reserves they need. So, over time the amount of money rises. But, this is a long-term gradual effect. When the demand for money rises certainly FRB will supply it and they will reduce the stock of money if the demand for it falls.
The ABCT is not directly connected. What has occurred in past business cycles is that central banks have taken control of the monetary system. They have then from time-to-time rapidly inflated (or sometimes deflated) the money supply causing the business cycle through the mechanisms described by ABCT.
>> I don’t think the risk is reduced much at all. Credit risk is
>> always the significant risk.
>
> Under FRB there is massive insolvency risk. This magnifies the
> credit risk. With my scenario there is zero financial risk to the
> depositor.
Why do you think that there is “massive insolvency risk”?
>> I support changing the law to ensure that banks are clearer in
>> Britain, I don’t think that such a change would alter the market
>> much though.
>
> Just my opinion but I suspect banks would strongly resist that. So
> would the government as they benefit strongly from the current
> system. I also think that if people realized just how much risk they
> were taking with FRB they would either demand a significantly higher
> interest rate (rather than the negative rates they get now) or would
> not put their money in FRB banks. Either would spell the end of FRB.
Historically speaking when people have had a choice they have chosen FRB. Before deposit insuarance people chose FRB even though they could have chosen safer 100% reserve banking. Similarly, in places without central banking FRB was chosen in preference to 100% reserve banking. So, why should things be different this time?
Current
November 28th, 2010 at 00:49 • Reply
Robert Sadler,
“However, in terms of banking “deposit” has meant debt since the 17th century.”
Do you mean from the banker’s perspective? For the most part bankers have certainly treated it as such although depositors did not view it the same way. Furthermore, even today banks obscure the difference using terms like “Current Account” (as you say) or “Checking Account”. I think today only economists use the term “Demand Deposit”. Legally and economically speaking I think it is very difficult to argue that a deposit can be defined as a debt.
“The problem with your argument here is that it’s not only the final deposit account that is money. Money is defined by the market not by abstract argument. If people decide to treat balances in “putable loan” accounts as money then they will become a money-substitute. Abstract argument about what underlies those accounts can’t change that.”
The main point is about the availability of the funds. With the putable bond the funds will exclusively available to one person. In FRB many people will have availability to the same funds. This is the key.
The main reason the bonds cannot be used as money is that they are not easily divisible (they come in certain denominations usually too large for your weekly food shopping) and they are of uncertain value (due to the credit rating and operating performance of the bank). You could certainly trade them but they would not be money any more than company shares would be.
Furthermore, they would compete in the marketplace with “real” hard money (i.e. gold). Would you rather be paid a deposit slip confirming your ownership of 100oz of gold or a risky bond with a face value of 100oz where the redemption amount and timing is uncertain?
> That’s how FRB (tries) to work but not how the Bank works in my
> example. A prudent bank would match up the duration of its assets
> and liabilities.
“No it won’t, banks have never done this. Certainly there is some risk
in mismatching assets, but not enough to prevent it being worthwhile.
Or, are you proposing that banks be banned from maturity transformation?”
I would hesitate to say banks have never done this. All financial institutions practice some form of duration management but obviously for FRB banks this is impossible (because the demand deposits have a virtual duration of zero). FRB banks do practice Gap Management where they try to limit the size of the duration gap between their assets and liabilities.
A 100% reserve bank would be able to reduce this gap to virtually zero and hence would be a fundamentally more stable institution.
> Btw where there is estimation there is
> error. Eventually, an FRB will make a critical error. If it can
> happen it will happen.
“Certainly it’s true that mistakes will occur. But, all contracts involve some degree of risk even if it’s very small. It’s down to the parties involved to decide how much of it they will take.”
This is a fair point and I agree that business is by its very nature, risky. However, FRB banks are perennially insolvent. No other business operates that way.
> Because the putable bonds will not be a money substitute. Putable
> bonds exist in the marketplace now and I have yet to hear of anyone
> using them as money.
“Yes, a present we have fractional reserve banking, it’s legal. What we’re arguing about is the situation that would prevail if it’s made illegal.”
Fair point.
> Arguably you could trade the value of your putable bond to someone
> for a good or service (or sell it for money) but the receiver would
> not confuse this risky bond for money.
“That’s only your opinion though. It’s up to those actually making the exchange to decide what they think about the risk.”
I didn’t mean to suggest that the riskiness of the bond would be an issue to the two parties. I meant that neither party would be confused as to whether they were buying a debt or receiving “real” money. Of course, the riskiness means that the bond will trade at a discount to face value. This again would make it difficult to use it as money.
“Let me put it like this: how many examples can you provide an example of banks that failed because it didn’t have enough reserves to service redemptions?”
One failure that is mentioned in that BIS report was Continental Illinois National Bank in 1984. It had a net worth of $2bn at the time of failure so it was not balance sheet insolvent. It failed because it could not liquidate assets quick enough to repay depositors (which is what you would expect given the asset/liability mismatch). Granted it was a couple of particularly large bad debt that created the panic but all banks have bad debts all the time. These particular debts were not large enough to bring down the bank but they destroyed the confidence the market previously had in the bank.
Fundamentally, Continental simply did not have the liquidity to meet cover all of its withdrawals. This bank was (balance sheet) solvent but would not sell its assets quick enough to satisfy redemptions. This would not be an issue for a 100% reserve bank. If this example doesn’t satisfy you there are others.
The important point is that FRB and hence the whole financial systems works on a system of confidence. Continental failed because its depositors lost confidence in it. If people in general lose confidence in the financial system it can all come crashing down. This is not an issue for a 100% reserve bank.
> If we can demonstrate a priori that bank runs absolutely can occur
> without a single bad loan having been made then we know that they
> absolutely will.
“Oh, I agree entirely that it can concievably happen. But, account holders are hardly going to concern themselves with that, the issue is the risk of it happening.”
They should.
“I agree that over time banks find ways to minimize the amount of reserves they need. So, over time the amount of money rises. But, this is a long-term gradual effect. When the demand for money rises certainly FRB will supply it and they will reduce the stock of money if the demand for it falls.”
It is not the place of banks to supply money. Banks are an intermediary matching borrowers and lenders. The creation of fiat money does not create value and it is value that is important for investment. In other words, investment must be backed by real savings not by abstract entries in a banks accounting system. Real savings are supplied by individuals who have produced goods of value, sold these goods and saved any surplus value once they have attended to their living costs. This surplus value can be transferred to banks to form a supply of investment capital to entrepreneurs.
If businesses or individuals have a demand for investment capital they can negotiate with these suppliers of investment capital an appropriate interest rate. When the demand for investment capital (i.e. real money) rises the interest rate will rise, thus motivating individuals to prefer investment over additional consumption, thus increasing the supply of investment capital. There is no need for banks to create fiat money to facilitate this process. Valueless fiat money will in fact lead to capital consumption as resources are wasted on projects that otherwise would not have been commenced if not for the money creation by FRB banks.
“The ABCT is not directly connected. What has occurred in past business cycles is that central banks have taken control of the monetary system. They have then from time-to-time rapidly inflated (or sometimes deflated) the money supply causing the business cycle through the mechanisms described by ABCT.”
These business cycles occur with FRB even without the existence of central banks.
“Why do you think that there is “massive insolvency risk”?”
With FRB bank is continuously insolvent. With FRB depositors assume this risk. With 100% reserves this is not the case.
“Historically speaking when people have had a choice they have chosen FRB. Before deposit insuarance people chose FRB even though they could have chosen safer 100% reserve banking. Similarly, in places without central banking FRB was chosen in preference to 100% reserve banking. So, why should things be different this time?”
I am not sure this is the case. As I understand it, historically bankers have been very deceptive about whether they have held fractional reserves or not. Over the past 300 years there have been many cases in which banks have been sued by their depositors when it has been discovered they did not keep 100% reserves at the bank. In the past, most people with bank accounts would have been relatively sophisticated businessmen. Nowadays, anyone with a heart beat can get a bank account. It is fair to say that today, most depositors are completely ignorant about who owns the money in their account, what reserves are etc. I would not say that the average person would know the difference between a fractional reserve account and a 100% reserve account (until the bank runs started) nor could they make an educated choice between the two.
> “However, in terms of banking “deposit” has meant debt since the
> 17th century.”
>
> Do you mean from the banker’s perspective? For the most part bankers
> have certainly treated it as such although depositors did not view
> it the same way.
Yes they did. See my reply to Toby Baxendale in this thread:
https://www.cobdencentre.org/2010/11/carswell-and-baker-on-bank-reform/
In the past anyone who paid attention to the world in even a limited way would notice that banknotes were debts.
The argument that bankers have been tricking people for hundreds of years doesn’t stand up to any scrutiny. As I said to Toby, why didn’t rival entrepreneurs start up 100% reserve banks if that’s what people wanted?
> Furthermore, even today banks obscure the
> difference using terms like “Current Account” (as you say) or
> “Checking Account”.
What’s wrong with those terms? A bank account is just like an “account” with a department store, it’s a debt the business owes to it’s customer.
> I think today only economists use the term
> “Demand Deposit”.
I think you’re probably right about that. It can be argued that the term “deposit” is confusing because a deposit at a warehouse means a bailment.
> Legally and economically speaking I think it is
> very difficult to argue that a deposit can be defined as a debt.
It’s not very difficult at all. Legally speaking current accounts are debts, and when there were private banknotes those were debts too. Economically speaking those things are both debts and money-substitutes.
> “The problem with your argument here is that it’s not only the final
> deposit account that is money. Money is defined by the market not by
> abstract argument. If people decide to treat balances in “putable
> loan” accounts as money then they will become a
> money-substitute. Abstract argument about what underlies those
> accounts can’t change that.”
>
> The main point is about the availability of the funds. With the
> putable bond the funds will exclusively available to one person. In
> FRB many people will have availability to the same funds. This is
> the key.
That’s true, but I don’t think it’s significant. All your change would mean in practice is that if a bank doesn’t estimate the amount of reserves it needs correctly then it can delay paying customers. It’s like an “option clause” except without the interest rate those clauses came with.
Since there isn’t much realistic chance that a bank will make a mistake in planning reserves it doesn’t really matter much.
I expect the main issue would be in relations between banks. In the interbank transfer market if Bank X had a grudge against Bank Y then it could refuse to redeem notes straight away and impose the waiting period. That would make bank transfers difficult.
> The main reason the bonds cannot be used as money is that they are
> not easily divisible (they come in certain denominations usually too
> large for your weekly food shopping) and they are of uncertain value
> (due to the credit rating and operating performance of the
> bank). You could certainly trade them but they would not be money
> any more than company shares would be.
You are looking at the situation as it is today. As I said earlier, today we have fractional-reserve banking, so we don’t need to re-invent it.
Bonds don’t come in small denominations because we have banknotes that do. Though bonds may be of “uncertain value” it isn’t really that uncertain. An issuer with high quality assets and a good reputation will not have a high risk premium.
> Furthermore, they would compete in the marketplace with “real” hard
> money (i.e. gold). Would you rather be paid a deposit slip
> confirming your ownership of 100oz of gold or a risky bond with a
> face value of 100oz where the redemption amount and timing is
> uncertain?
If the “redemption amount and timing” were uncertain then a deposit slip would be preferable. But, why should the redemption amount and timing be uncertain? Banks can agree to redeem the full amount whenever the depositor asks, and they can provide interest and banking services too.
Even if 100% reserve advocates take over the government and ban banks from agreeing to provide these things they can still provide them anyway. Customers can rely on reputation to decide which banks will fulfill their promises. Perhaps the government can knobble banks sufficiently that they couldn’t function like this, I don’t know but they’d have to try quite hard.
>> That’s how FRB (tries) to work but not how the Bank works in my
>> example. A prudent bank would match up the duration of its assets
>> and liabilities.
>
> “No it won’t, banks have never done this. Certainly there is some risk
> in mismatching assets, but not enough to prevent it being worthwhile.
>
> Or, are you proposing that banks be banned from maturity transformation?”
>
> I would hesitate to say banks have never done this. All financial
> institutions practice some form of duration management
Yes, but maturity matching is very rare.
> but obviously
> for FRB banks this is impossible (because the demand deposits have a
> virtual duration of zero). FRB banks do practice Gap Management
> where they try to limit the size of the duration gap between their
> assets and liabilities.
What’s the practical difference betweeen “gap management” and “duration management”? What’s a “virtual duration” for that matter?
Certainly current-account customers can withdraw their money whenever they like, but in practice it’s possible to predict the outflow of redemptions.
> A 100% reserve bank would be able to reduce this gap to virtually
> zero and hence would be a fundamentally more stable institution.
But, that doesn’t mean that the price of that extra stability is something the public consider worth paying for. 100% reserve banking has never been illegal, but even in places without deposit insurance it hasn’t succeeded commerically.
>> Btw where there is estimation there is
>> error. Eventually, an FRB will make a critical error. If it can
>> happen it will happen.
>
> “Certainly it’s true that mistakes will occur. But, all contracts
> involve some degree of risk even if it’s very small. It’s down to
> the parties involved to decide how much of it they will take.”
>
> This is a fair point and I agree that business is by its very
> nature, risky. However, FRB banks are perennially insolvent. No
> other business operates that way.
No they aren’t. A business is insolvent if the value of it’s liabilities exceeds that of it’s assets. If an FRB becomes insolvent then there is normally a run on it. (And trading in insolvency is illegal anyway).
>> Arguably you could trade the value of your putable bond to someone
>> for a good or service (or sell it for money) but the receiver would
>> not confuse this risky bond for money.
>
> “That’s only your opinion though. It’s up to those actually making
> the exchange to decide what they think about the risk.”
>
> I didn’t mean to suggest that the riskiness of the bond would be an
> issue to the two parties. I meant that neither party would be
> confused as to whether they were buying a debt or receiving “real”
> money.
Yes, and that’s certainly a good thing.
> Of course, the riskiness means that the bond will trade at a
> discount to face value. This again would make it difficult to use it
> as money.
Not necessarily. My bank account doesn’t “trade at a discount”, and nor did bank accounts trade at a discount before deposit insurance. The reason is that banks provide extra services that commodity money doesn’t provide which compensate the holder for the extra risk. And, of-course, some accounts pay interest too.
> “Let me put it like this: how many examples can you provide an
> example of banks that failed because it didn’t have enough reserves
> to service redemptions?”
>
> One failure that is mentioned in that BIS report was Continental
> Illinois National Bank in 1984. It had a net worth of $2bn at the
> time of failure so it was not balance sheet insolvent. It failed
> because it could not liquidate assets quick enough to repay
> depositors (which is what you would expect given the asset/liability
> mismatch). Granted it was a couple of particularly large bad debt
> that created the panic but all banks have bad debts all the
> time. These particular debts were not large enough to bring down the
> bank but they destroyed the confidence the market previously had in
> the bank.
>
> Fundamentally, Continental simply did not have the liquidity to meet
> cover all of its withdrawals. This bank was (balance sheet) solvent
> but would not sell its assets quick enough to satisfy
> redemptions. This would not be an issue for a 100% reserve bank. If
> this example doesn’t satisfy you there are others.
But, in this case the market had a good reason to think that the bank may be insolvent. I agree that sometimes (though it doesn’t happen often) banks become bankrupt because the market thinks they have enough bad debts that they are bankrupt.
But, the normal Rothbardian argument is that redemptions are impossible to predict in principle. If this were true it should be possible to find examples of banks that failed without any rumours.
I agree that this problem doesn’t occur in a 100% system. But, I don’t think that it necessarily gives customers sufficient reason to demand 100% reserve banking. Especially since failures like this are rare, normally when rumours bring down a bank the rumours turn out to have been true.
> The important point is that FRB and hence the whole financial
> systems works on a system of confidence. Continental failed because
> its depositors lost confidence in it. If people in general lose
> confidence in the financial system it can all come crashing
> down. This is not an issue for a 100% reserve bank.
In a 100% reserve system there must still be borrowing and lending, even if it is timed. In that situation there can still be confidence issues. If the savers believe the bank’s assets are bad they may not roll-over their bonds.
>> If we can demonstrate a priori that bank runs absolutely can occur
>> without a single bad loan having been made then we know that they
>> absolutely will.
>
> “Oh, I agree entirely that it can concievably happen. But, account
> holders are hardly going to concern themselves with that, the issue
> is the risk of it happening.”
>
> They should.
Why? It is possible a priori that there exists an orange penguin that want’s to kill me. But this doesn’t concern me much :)
> “I agree that over time banks find ways to minimize the amount of
> reserves they need. So, over time the amount of money rises. But,
> this is a long-term gradual effect. When the demand for money rises
> certainly FRB will supply it and they will reduce the stock of money
> if the demand for it falls.”
>
> It is not the place of banks to supply money.
> Banks are an intermediary matching borrowers and lenders.
It could be argued that “a pub is a place where people drink alcoholic drinks”. And therefore “it is not the place of a pub to supply meals”.
But, just because someone argues that doesn’t mean that a pub can’t legally or morally supply meals.
> The creation of fiat money does not create value and it is value
> that is important for investment. In other words, investment must be
> backed by real savings not by abstract entries in a banks accounting
> system. Real savings are supplied by individuals who have produced
> goods of value, sold these goods and saved any surplus value once
> they have attended to their living costs. This surplus value can be
> transferred to banks to form a supply of investment capital to
> entrepreneurs.
We’re not talking about fiat money here, we’re talking about fiduciary media.
Fiduciary media doesn’t create “false savings”. When you hold £1 in your bank account you are loaning £1 to the bank and the bank is loaning it to someone else. For every asset there is a matching liability.
> If businesses or individuals have a demand for investment capital
> they can negotiate with these suppliers of investment capital an
> appropriate interest rate. When the demand for investment capital
> (i.e. real money) rises the interest rate will rise, thus motivating
> individuals to prefer investment over additional consumption, thus
> increasing the supply of investment capital. There is no need for
> banks to create fiat money to facilitate this process. Valueless
> fiat money will in fact lead to capital consumption as resources are
> wasted on projects that otherwise would not have been commenced if
> not for the money creation by FRB banks.
Banks don’t create fiat money, governments create fiat money. Banks create fiduciary media. I agree with the rest of your little summary of ABCT theory though.
> “The ABCT is not directly connected. What has occurred in past
> business cycles is that central banks have taken control of the
> monetary system. They have then from time-to-time rapidly inflated
> (or sometimes deflated) the money supply causing the business cycle
> through the mechanisms described by ABCT.”
>
> These business cycles occur with FRB even without the existence of
> central banks.
Perhaps. This is a very difficult area of economic history. Certainly the business cycle has occurred without central banks. But, it is difficult to claim that ABCT has occurred without them. (I know that’s what Rothbard said about 1819, but it’s really quite uncertain).
How would ABCT occur in a fractional-reserve free banking system?
> “Why do you think that there is “massive insolvency risk”?”
>
> With FRB bank is continuously insolvent. With FRB depositors assume
> this risk. With 100% reserves this is not the case.
As I pointed out above FR banks aren’t insolvent. In fact you pointed that out too in your example of Continental Illonois bank.
> “Historically speaking when people have had a choice they have
> chosen FRB. Before deposit insuarance people chose FRB even though
> they could have chosen safer 100% reserve banking. Similarly, in
> places without central banking FRB was chosen in preference to 100%
> reserve banking. So, why should things be different this time?”
>
> I am not sure this is the case. As I understand it, historically
> bankers have been very deceptive about whether they have held
> fractional reserves or not.
In some case they have but not in as many as Rothbardians suppose. See my reply to Toby I mentioned above.
> Over the past 300 years there have been many cases in which banks
> have been sued by their depositors when it has been discovered they
> did not keep 100% reserves at the bank.
Well, all that really shows is that some depositors didn’t educate themselves about what they were getting into.
> In the past, most people with bank accounts would have been
> relatively sophisticated businessmen. Nowadays, anyone with a heart
> beat can get a bank account. It is fair to say that today, most
> depositors are completely ignorant about who owns the money in their
> account, what reserves are etc. I would not say that the average
> person would know the difference between a fractional reserve
> account and a 100% reserve account (until the bank runs started) nor
> could they make an educated choice between the two.
I would say that people are uneducated about this today because deposit insurance means they don’t have to be educated. The government protects them so they don’t look into the details. And this is why people are uneducated about a lot of other things too.
I’m generally a libertarian but I’m not averse to a little paternalism, so I agree with the proposal to force banks to explicitly state things. Let’s have bank accounts where the paperwork clearly states that they are debts, and I wouldn’t mind if the word “deposit” were banned too.
> Do you mean from the banker’s perspective? For the most part bankers
> have certainly treated it as such although depositors did not view
> it the same way.
“Yes they did. See my reply to Toby Baxendale in this thread:
https://www.cobdencentre.org/2010/11/carswell-and-baker-on-bank-reform/
In the past anyone who paid attention to the world in even a limited way would notice that banknotes were debts.
The argument that bankers have been tricking people for hundreds of years doesn’t stand up to any scrutiny. As I said to Toby, why didn’t rival entrepreneurs start up 100% reserve banks if that’s what people wanted?”
I see your point (about deposits) but I don’t think your reply to Toby addresses the definition of deposit or prove that it meant “debt.” You appear to be arguing that banking customers were fine with FRB. I don’t know this to be the case. In fact, banks were sued in court in the 19th Century (Foley v Hill 1848) by their customers because they were treating deposits as debt. While the court found for the banks the mere fact they were sued suggests that depositors did not agree that a deposit meant debt.
As for why rival entrepreneurs didn’t start up 100% reserve banks… well they have. I know a good one if you’re interested.
• “What’s wrong with those terms? A bank account is just like an “account” with a department store, it’s a debt the business owes to it’s customer.”
My point is that if it is widely accepted that a deposit is a debt then the banks should not need these other terms (RE current and checking accounts). They could just call it a “deposit account.” I think you made clear the problem with your comment about bailments.
> Legally and economically speaking I think it is
> very difficult to argue that a deposit can be defined as a debt.
• “It’s not very difficult at all. Legally speaking current accounts are debts, and when there were private banknotes those were debts too. Economically speaking those things are both debts and money-substitutes.”
De Soto makes the point in MBC&EC 1998. Legally speaking to say a deposit is a debt is contradictory because the actions of one party to the deposit contract will frustrate the objectives of the other, making the contract null and void. Economically speaking it is contradictory because a debt logically must have a term (by when it is to be repaid). Deposits do not have a term.
> The main point is about the availability of the funds. With the
> putable bond the funds will exclusively available to one person. In
> FRB many people will have availability to the same funds. This is
> the key.
• “That’s true, but I don’t think it’s significant. All your change would mean in practice is that if a bank doesn’t estimate the amount of reserves it needs correctly then it can delay paying customers. It’s like an “option clause” except without the interest rate those clauses came with.”
But they have made these mistakes in the past. These mistakes have only become less frequent since central banks became the lender of last resort. Further, it simply isn’t possible that FRB banks can insure they will always have sufficient reserves because nobody can predict the point at which a boom period will end and the recession will begin, revealing all of the malinvestments. FRB banks will eventually be caught out. This is guaranteed.
The availability point is highly significant because if you have multiple parties to whom the funds are available, the money supply is expanded (i.e. inflation), which is the fundamental cause of the business cycle.
> The main reason the bonds cannot be used as money is that they are
> not easily divisible (they come in certain denominations usually too
> large for your weekly food shopping) and they are of uncertain value.
• “Bonds don’t come in small denominations because we have banknotes that do. Though bonds may be of “uncertain value” it isn’t really that uncertain. An issuer with high quality assets and a good reputation will not have a high risk premium.”
Granted but there are reason bonds come in high denominations: administration costs and the ability to lock in a fixed minimum amount of money for a specific period of time. It also makes it somewhat predictable to determine how much will be redeemed at one time (or at least by what factor). This is very convenient. Bonds also come in high denominations because they represent a standardised contract which makes them easily tradable.
Your objection appears to be slightly circular since we can turn it around: if we have banknotes in small denominations we don’t need bonds in small denominations. That aside, the point is, a banknote (as a deposit receipt) backed by specie is far superior as money to a risky bond backed by the ability of a bank to pay. I can’t imagine that a businessman or employee would prefer to be paid in debt instruments rather than hard money backed by real goods. And sure, a good bank will not be “that uncertain” but it will still be “uncertain”. Not an issue with real goods as money.
In the marketplace, real goods as money are clearly superior to debt instruments and debt instruments would have to be discounted. We know this because the holder of a debt needs to be paid interest. Perhaps you are indifferent between the two but I don’t see that as being rational.
• “If the “redemption amount and timing” were uncertain then a deposit slip would be preferable. But, why should the redemption amount and timing be uncertain? Banks can agree to redeem the full amount whenever the depositor asks, and they can provide interest and banking services too.”
The redemption amount and timing are uncertain because a bond is a risky asset by definition. How uncertain and how risky is reflected in the risk premium. This would not be the case with a 100% reserve institution.
• “Yes, but maturity matching is very rare.”
It would be expensive and impractical, I agree.
• “What’s the practical difference between “gap management” and “duration management”? What’s a “virtual duration” for that matter?”
Certainly current-account customers can withdraw their money whenever they like, but in practice it’s possible to predict the outflow of redemptions.
Duration is the measure of debt instruments price sensitivity to movements in interest rates. If rates go up the value of your portfolio goes down. Duration is a measure of how much it will go down. For financial institutions that need to keep the value of their assets >= to liabilities this is a key measure. The management comes in terms of how much to let the relative durations of the assets and liabilities differ from each other. If you think rates will go up then you would want the duration of the liabilities to be higher than the assets. If rates will go down, you would want the opposite.
Banks can never match their asset and liability durations. Liabilities will have much shorter duration meaning there is a big gap in the relative durations. Gap management is the process of keeping this gap as small as possible. Its similar to duration management but with a different focus (and is unique to banks).
There’s no such thing as virtual duration just my bad grammar. I meant “a duration of virtually zero”.
• “But, that doesn’t mean that the price of that extra stability is something the public consider worth paying for. 100% reserve banking has never been illegal, but even in places without deposit insurance it hasn’t succeeded commercially.”
I personally do pay for it and I know others that do. I think anyone who has lost money in a bank would pay for that extra stability. I think that the problem is that most people just assume that their money is safe in the bank. Recently, a new generation of people have realised that it isn’t. Let’s not also forget that if you currently keep your savings in the bank you are paying anyway through the inflation tax. And not getting any stability at all. Whereas if you put your money in a 100% gold backed depository institution you will actually earn money (in currency terms).
• “No they aren’t. A business is insolvent if the value of it’s liabilities exceeds that of it’s assets. If an FRB becomes insolvent then there is normally a run on it. (And trading in insolvency is illegal anyway).”
A business is also insolvent if it cannot pay its debts as they become due (even if its assets > liabilities). Since a banks debts are always “on-demand” they cannot pay them as they fall due).
• “Not necessarily. My bank account doesn’t “trade at a discount”, and nor did bank accounts trade at a discount before deposit insurance. The reason is that banks provide extra services that commodity money doesn’t provide which compensate the holder for the extra risk. And, of-course, some accounts pay interest too.”
Well, bank accounts don’t trade at all. What would say though is that if you have an ordinary current or savings account then it is continuously losing value in real terms. What are these extra services you refer to?
• “But, the normal Rothbardian argument is that redemptions are impossible to predict in principle. If this were true it should be possible to find examples of banks that failed without any rumours.”
I don’t follow: do you mean mass redemptions? If so, how would whether there were rumours or not make a difference to predicting this? How would the bank be able to predict if or when there were going to be rumours?
In any case, a number of small banks failed in England in the early Nineties because their depositors lost confidence in them. There were no bad debts or rumours beyond the fact that the depositors just didn’t think the banks could survive the recession. These banks had reserve ratios far higher than the regulatory minimum.
• “I agree that this problem doesn’t occur in a 100% system. But, I don’t think that it necessarily gives customers sufficient reason to demand 100% reserve banking. Especially since failures like this are rare, normally when rumours bring down a bank the rumours turn out to have been true.”
Banking failures occur every business cycle for a variety of reasons. In my view, FRB survived on this occasion (i.e. current financial crisis) because of the massive intervention of governments, over and above the intervention of the central bank. Think about that for a second. Central banks were instituted as a lender of last resort to help FRB banks survive. That failed and now governments have stepped into the breach to help the system survive. And they are hanging on by their fingertips.
Eventually, governments will fail too. At this point, when customers start making visible losses they will demand 100% reserve banking.
• “In a 100% reserve system there must still be borrowing and lending, even if it is timed. In that situation there can still be confidence issues. If the savers believe the bank’s assets are bad they may not roll-over their bonds.”
Agreed but while the savers (lenders) may be at risk of losing all or a portion of their funds the depositors’ funds will be safe.
• “Why? It is possible a priori that there exists an orange penguin that want’s to kill me. But this doesn’t concern me much :)”
Penguins were my favourite chocolate biscuit as a child but I am quite sure that if you failed to chew it sufficiently and perhaps try to swallow it whole, it could choke you to death :-)
I say that account holders should concern themselves with it because the risk is real and they could make real losses.
• “It could be argued that “a pub is a place where people drink alcoholic drinks”. And therefore “it is not the place of a pub to supply meals”.But, just because someone argues that doesn’t mean that a pub can’t legally or morally supply meals.”
The point is that is if a bank “supplies money” then it is not supplying anything of value. Liken that to a pub giving you a meal that when you stick your fork into it, it disintegrates into inedible dust.
• We’re not talking about fiat money here, we’re talking about fiduciary media.
I am using the Mankiw definition here: money without intrinsic value. I agree that fiduciary media is a more accurate term for what we are discussing though.
• Fiduciary media doesn’t create “false savings”. When you hold £1 in your bank account you are loaning £1 to the bank and the bank is loaning it to someone else. For every asset there is a matching liability.
That is really only an accounting relationship. It’s like saying 2 + 2 = 4. I know that you are aware that accountants can pull all sorts of tricks to make the books look good. The problem is that accounts are a derivative of reality; they are not reality itself.
• Banks don’t create fiat money, governments create fiat money. Banks create fiduciary media. I agree with the rest of your little summary of ABCT theory though.
Just substitute “fiduciary media” for “fiat currency” and the result is the same. I intended this as a highly simplistic description of capital theory rather than ABCT although I appreciate it can easily be interpreted as such. My point is that that is no need for “fiduciary media” or banks “supplying money” in order for the economy to flourish. In fact, just the opposite is what the economy needs. The point is that individuals are the suppliers of capital (read: present goods) not banks, and this capital represents their real savings.
• “How would ABCT occur in a fractional-reserve free banking system?”
It would be just like it is now with central banking but likely not as severe. The same fundamentals are in place: expansion of the money supply not backed by specie, artificially reduced interest rates, increased inflation, malinvestment etc. The best description of how this occurs in De Soto’s Money, Bank Credit and Economic Cycles, chapter 5. You can get a pdf online easily. In fact Current, if you get through the first five chapters of De Soto’s book and are still a free banker, I’ll buy you two pints of beer. How’s that for motivation?
• “As I pointed out above FR banks aren’t insolvent. In fact you pointed that out too in your example of Continental Illinois bank.”
Continental Illinois was balance sheet solvent but cash-flow insolvent.
• “Well, all that really shows is that some depositors didn’t educate themselves about what they were getting into.”
I know, what a bunch of fools! :-)
Actually, I think the truth is more complicated. Before the mid-nineteenth century there wasn’t much legal support for fractional reserve banking (in the UK). Also, a lot of bankers were very deceptive and/or secretive about what they were doing, hence the lawsuits.
• “I would say that people are uneducated about this today because deposit insurance means they don’t have to be educated. The government protects them so they don’t look into the details. And this is why people are uneducated about a lot of other things too.”
Do you think deposit insurance should be abolished?
>> The argument that bankers have been tricking people for hundreds of
>> years doesn’t stand up to any scrutiny. As I said to Toby, why
>> didn’t rival entrepreneurs start up 100% reserve banks if that’s
>> what people wanted?”
>
> I see your point (about deposits) but I don’t think your reply to
> Toby addresses the definition of deposit or prove that it meant
> “debt.” You appear to be arguing that banking customers were fine
> with FRB. I don’t know this to be the case. In fact, banks were sued
> in court in the 19th Century (Foley v Hill 1848) by their customers
> because they were treating deposits as debt. While the court found
> for the banks the mere fact they were sued suggests that depositors
> did not agree that a deposit meant debt.
The Foley vs Hill case wasn’t really about that. It was about the situation where the same person is in debt to a bank and in credit to the same bank at the same time. It was about whether the banker is obliged to offset debt against credit, and adjust interest rates accordingly or if he can use his discretion. As far as I understand it the court decided that the banker only has to pay back the difference between debt and credit, and that it’s at the bankers discretion whether he offsets interest rates. AFAIK the banker only has to offset interest rates if that’s what was explicitly agreed. You can read about this case on the internet.
Even before Carr vs Carr in 1811 the judgements of courts indicated that handing over money to a banker meant surrendering ownership of it.
> As for why rival entrepreneurs didn’t start up 100% reserve
> banks… well they have. I know a good one if you’re interested.
Then please tell!
>> What’s wrong with those terms? A bank account is just like an
>> “account” with a department store, it’s a debt the business owes to
>> it’s customer.
>
>
> My point is that if it is widely accepted that a deposit is a debt
> then the banks should not need these other terms (RE current and
> checking accounts). They could just call it a “deposit account.” I
> think you made clear the problem with your comment about bailments.
Generally “deposit” does mean a bailment legally. If I “deposit” a couch with a warehouse then they can’t sell it. But, for money it’s different “deposit account” means a debt. In my view that’s confusing.
>>> Legally and economically speaking I think it is
>>> very difficult to argue that a deposit can be defined as a debt.
>>
>> It’s not very difficult at all. Legally speaking current accounts
>> are debts, and when there were private banknotes those were debts
>> too. Economically speaking those things are both debts and
>> money-substitutes.
>
> De Soto makes the point in MBC&EC 1998. Legally speaking to say a
> deposit is a debt is contradictory because the actions of one party
> to the deposit contract will frustrate the objectives of the other,
> making the contract null and void.
I don’t see how. What we’re talking about here is an agreement to pay a debt on demand. The borrower agrees to pay whenever the lender requests payment. It’s true that when the lender requests payment that the borrower must stump up specie and that may “frustrate” his objectives. But, that’s his problem, if he doesn’t he’s in breach.
> Economically speaking it is contradictory because a debt logically
> must have a term (by when it is to be repaid). Deposits do not have
> a term.
Why must a debt have a term? As I see in the fundamental concept of debt is that one person must pay something to another person under certain conditions that are agreed beforehand. In my view if those conditions don’t involve a specific date, but instead use some other arrangement, then the contract is still a debt.
>>> The main point is about the availability of the funds. With the
>>> putable bond the funds will exclusively available to one person. In
>>> FRB many people will have availability to the same funds. This is
>>> the key.
>>
>> That’s true, but I don’t think it’s significant. All your change
>> would mean in practice is that if a bank doesn’t estimate the
>> amount of reserves it needs correctly then it can delay paying
>> customers. It’s like an “option clause” except without the interest
>> rate those clauses came with.
>
> But they have made these mistakes in the past. These mistakes have
> only become less frequent since central banks became the lender of
> last resort.
As far as I know, mistakes in planning liquidity have never being very common. I agree that central banks help and support banks that would otherwise go bankrupt. All this means though is that without central banking banks may have to keep more reserves.
As I said earlier, in practice the greatest threat to banks has come from bad management of their loan assets.
> Further, it simply isn’t possible that FRB banks can
> insure they will always have sufficient reserves because nobody can
> predict the point at which a boom period will end and the recession
> will begin, revealing all of the malinvestments. FRB banks will
> eventually be caught out. This is guaranteed.
I don’t really see what booms and busts have to do with this aspect of it. In general a bust means that demand for money holdings rises. People hold more static balances in their bank accounts and transfer less. This means banks require less reserves not more.
Demand for reserves rises in booms when the demand for money falls and the velocity of circulation rises.
> The availability point is highly significant because if you have
> multiple parties to whom the funds are available, the money supply
> is expanded (i.e. inflation), which is the fundamental cause of the
> business cycle.
Certainly, when fractional reserve banking first becomes possible the supply of money expands and that would cause inflation. But, we now live centuries since that happened. What concerns us now is the economic forces that apply to *changes* in the quantity of money and the level of prices.
>> Bonds don’t come in small denominations because we have banknotes
>> that do. Though bonds may be of “uncertain value” it isn’t really
>> that uncertain. An issuer with high quality assets and a good
>> reputation will not have a high risk premium.
>
> Granted but there are reason bonds come in high denominations:
> administration costs and the ability to lock in a fixed minimum
> amount of money for a specific period of time. It also makes it
> somewhat predictable to determine how much will be redeemed at one
> time (or at least by what factor). This is very convenient. Bonds
> also come in high denominations because they represent a
> standardised contract which makes them easily tradable.
Yes.
> Your objection appears to be slightly circular since we can turn it
> around: if we have banknotes in small denominations we don’t need
> bonds in small denominations.
I don’t see how that makes it circular, but you’re right if we have banknotes we don’t need bonds in small denominations. If we don’t have banknotes then bonds in small denominations will arise, something I’ll come on to below.
> That aside, the point is, a banknote (as a deposit receipt) backed
> by specie is far superior as money to a risky bond backed by the
> ability of a bank to pay. I can’t imagine that a businessman or
> employee would prefer to be paid in debt instruments rather than
> hard money backed by real goods. And sure, a good bank will not be
> “that uncertain” but it will still be “uncertain”. Not an issue with
> real goods as money.
I agree that there is a degree of uncertainty in using debt instruments rather than commodity money. But, the issue is the degree of risk involved and whether there are other compensating factors. There often are other compensating factors, such as interest payments and banking services provided without charge.
From time-to-time legal prohibitions, or other problems have prevented issue of banknote from being practical in some places. The North of England in the 19th century for example. Merchants there could have switched to using coins exclusively, but they didn’t. Instead “sight bills” arose which were a form of short-term debt used as payment.
> In the marketplace, real goods as money are clearly superior to debt
> instruments and debt instruments would have to be discounted. We
> know this because the holder of a debt needs to be paid
> interest. Perhaps you are indifferent between the two but I don’t
> see that as being rational.
If I were offered a choice between a gold coin and a current account a gold coin from a reputable banker then all other things being equal the latter comes with a greater risk than the former, so the former is more valuable. But, all the other things aren’t equal. The bank account may haveextra services that make it more than worth my while to take some extra risk. They may provide simpler payments than coins can, or regular automatic payments free of charge.
>> If the “redemption amount and timing” were uncertain then a deposit
>> slip would be preferable. But, why should the redemption amount and
>> timing be uncertain? Banks can agree to redeem the full amount
>> whenever the depositor asks, and they can provide interest and
>> banking services too.
>
> The redemption amount and timing are uncertain because a bond is a
> risky asset by definition. How uncertain and how risky is reflected
> in the risk premium.
I thought you meant that the bank should be able to have the option of not paying it’s debts without recourse. I see now that all you mean is that the bank could default, in that case I agree.
> This would not be the case with a 100% reserve institution.
The difference in risk here is not an absolute one. A 100% reserve bank doesn’t have the risk of bad debts, or of running out of specie for redemptions. It still entails the risk of being robbed, the bank customer still could be swindled by the bank. Whether the total risk taken is greater or lesser in any situation depends on the circumstances.
For example, suppose I decided to keep all my money at home in a suitcase and call that my personal 100% reserve bank. That may be less secure than putting money into a bank account because my house could be burgled.
>> Yes, but maturity matching is very rare.
>
> It would be expensive and impractical, I agree.
Oh good :)
>> What’s the practical difference between “gap management” and
>> “duration management”? What’s a “virtual duration” for that matter?
>> Certainly current-account customers can withdraw their money
>> whenever they like, but in practice it’s possible to predict the
>> outflow of redemptions.
>
> Duration is the measure of debt instruments price sensitivity to
> movements in interest rates. If rates go up the value of your
> portfolio goes down. Duration is a measure of how much it will go
> down. For financial institutions that need to keep the value of
> their assets >= to liabilities this is a key measure. The management
> comes in terms of how much to let the relative durations of the
> assets and liabilities differ from each other. If you think rates
> will go up then you would want the duration of the liabilities to be
> higher than the assets. If rates will go down, you would want the
> opposite.
Fair enough, I agree with you there.
> Banks can never match their asset and liability
> durations. Liabilities will have much shorter duration meaning there
> is a big gap in the relative durations. Gap management is the
> process of keeping this gap as small as possible. Its similar to
> duration management but with a different focus (and is unique to
> banks).
Fair enough.
> There’s no such thing as virtual duration just my bad grammar. I
> meant “a duration of virtually zero”.
OK.
>> But, that doesn’t mean that the price of that extra stability is
>> something the public consider worth paying for. 100% reserve
>> banking has never been illegal, but even in places without deposit
>> insurance it hasn’t succeeded commercially.
>
> I personally do pay for it and I know others that do. I think anyone
> who has lost money in a bank would pay for that extra stability.
Just because a person has lost money, or because they could, doing something doesn’t mean that they will necessarily avoid doing it in the future. I’ve lost money putting it into vending machines, but I still use them from time to time.
We all make personal judgements about the risks involved. You’ve made yours and I’ve made mine and they’re different.
> I think that the problem is that most people just assume that their
> money is safe in the bank.
Generally speaking though it is quite safe. Though much of the reason for that today is government intervention not banking prudence. But it could be due to banking prudence and has been in the past.
> Recently, a new generation of people have
> realised that it isn’t. Let’s not also forget that if you currently
> keep your savings in the bank you are paying anyway through the
> inflation tax. And not getting any stability at all. Whereas if you
> put your money in a 100% gold backed depository institution you will
> actually earn money (in currency terms).
But today gold isn’t money as it was in the past. If you want to buy something you can’t exchange gold for it. Almost everywhere you have to use fiat money.
Keeping gold is a form of investment, not holding money. If you want to buy something then you have to sell some gold, get a normal bank balance or cash and buy it.
>> No they aren’t. A business is insolvent if the value of it’s
>> liabilities exceeds that of it’s assets. If an FRB becomes
>> insolvent then there is normally a run on it. (And trading in
>> insolvency is illegal anyway).
>
> A business is also insolvent if it cannot pay its debts as they
> become due (even if its assets > liabilities). Since a banks debts
> are always “on-demand” they cannot pay them as they fall due).
The question is whether *in practice* a bank can pay it’s debts as they fall due. The answer is that except in exceptional cases it can, and therefore it’s solvent.
That a bank could not pay if all of its current account holders redeemed at once isn’t relevant. The law is concerned with what people are likely to do, not what they could theoretically do.
Think about applying the same standard to all other businesses. There are many circumstances that could occur when other businesses are in the same position.
>> Not necessarily. My bank account doesn’t “trade at a discount”,
>> and nor did bank accounts trade at a discount before deposit
>> insurance. The reason is that banks provide extra services that
>> commodity money doesn’t provide which compensate the holder for the
>> extra risk. And, of-course, some accounts pay interest too.
>
> Well, bank accounts don’t trade at all.
What I mean is, if I have a gas bill for 100 euro then I make a transfer of 100 euro to my gas company. I don’t have to transfer 101 euro to make up for my account trading at a discount.
> What would say though is that if you have an ordinary current or
> savings account then it is continuously losing value in real
> terms.
Yes. But, investments don’t have the liquidity and convenience of money or money substitutes like bank accounts.
> What are these extra services you refer to?
Banking services: transfers, payments, cheques, automatic transfers, etc.
>> But, the normal Rothbardian argument is that redemptions are
>> impossible to predict in principle. If this were true it should be
>> possible to find examples of banks that failed without any rumours.
>
> I don’t follow: do you mean mass redemptions? If so, how would
> whether there were rumours or not make a difference to predicting
> this? How would the bank be able to predict if or when there were
> going to be rumours?
A bank can ensure that rumours would not be believed if it kept a large enough amount of capital above liabilities.
There is no possibility of certainty, but there again there isn’t any possibility of that in any other aspect of human life.
> In any case, a number of small banks failed in England in the early
> Nineties because their depositors lost confidence in them. There
> were no bad debts or rumours beyond the fact that the depositors
> just didn’t think the banks could survive the recession. These banks
> had reserve ratios far higher than the regulatory minimum.
What does a person mean when he says that a business can’t “survive the recession”? I think this means that he’s judging that the assets that the business has are not worth enough to pay for the liabilities and turn a profit.
You could say that it means that the assets are worth X now but will be worth X-Y later. But, unless that difference is close to the interest rate, what that really means is that the person doing the valuing thinks that the assets aren’t really worth X now.
Incidentally, why didn’t these banks borrow reserves from the Bank of England?
>> I agree that this problem doesn’t occur in a 100% system. But, I
>> don’t think that it necessarily gives customers sufficient reason to
>> demand 100% reserve banking. Especially since failures like this are
>> rare, normally when rumours bring down a bank the rumours turn out
>> to have been true.
>
> Banking failures occur every business cycle for a variety of
> reasons. In my view, FRB survived on this occasion (i.e. current
> financial crisis) because of the massive intervention of
> governments, over and above the intervention of the central
> bank. Think about that for a second. Central banks were instituted
> as a lender of last resort to help FRB banks survive. That failed
> and now governments have stepped into the breach to help the system
> survive. And they are hanging on by their fingertips.
Central banks were certainly not instituted to help FRB banks survive. They were instituted so governments could profit from banking.
You are certainly right that banking is in a mess right now. I would argue though that this is because of government interventions such as past bailouts, fiat money and central banking. And they have failed because of the business cycle brought about by inflation orchestrated by the central banks.
Remember, in the recent crisis and recession banks have failed principally because of bad investments. In my view the solution is to remove the interventions that insulate bank shareholders and managers from the consequences of bad investments.
But, none of this is the same thing as forcing banks to hold their assets in a particular form.
> Eventually, governments will fail too. At this point, when customers
> start making visible losses they will demand 100% reserve banking.
I doubt they will ever demand 100% reserve banking. In the instances of free banking that have been studied banks used fractional reserves. Since the normal demand for redemptions is predictable a bank can invest in loans, so why would 100% reserve banking come into use.
That doesn’t mean that anything like modern day banking would be practical without government intervention, it wouldn’t be. The protection governments provide today is not what allows low levels of reserves to be used. As Selgin often points out Scottish free banks used ~2.5% reserves, much less than many banks do today. But, they kept an amount of clear capital, that is Assets minus Liabilities much greater than modern banks do.
>> In a 100% reserve system there must still be borrowing and lending,
>> even if it is timed. In that situation there can still be
>> confidence issues. If the savers believe the bank’s assets are bad
>> they may not roll-over their bonds.
>
> Agreed but while the savers (lenders) may be at risk of losing all
> or a portion of their funds the depositors’ funds will be safe.
Yes. My point is that it really doesn’t prevent banking crises. It could removes on-demand accounts from involvement in them certainly.
>> Why? It is possible a priori that there exists an orange penguin
>> that want’s to kill me. But this doesn’t concern me much :)
>
> Penguins were my favourite chocolate biscuit as a child but I am
> quite sure that if you failed to chew it sufficiently and perhaps
> try to swallow it whole, it could choke you to death :-)
>
> I say that account holders should concern themselves with it because
> the risk is real and they could make real losses.
I agree they should, but that doesn’t mean they will consider it great enough to use 100% reserve banking.
>> It could be argued that “a pub is a place where people drink
>> alcoholic drinks”. And therefore “it is not the place of a pub to
>> supply meals”. But, just because someone argues that doesn’t mean
>> that a pub can’t legally or morally supply meals.
>
> The point is that is if a bank “supplies money” then it is not
> supplying anything of value. Liken that to a pub giving you a meal
> that when you stick your fork into it, it disintegrates into
> inedible dust.
What about banking services? Surely they have value? What about interest?
Banks have value to all of those who interact with them. To current account holders they provide a money subsitute that it superior in some respects to cash. To savings account customers they provide interest. To borrowers they provide loans and to their shareholders they provide profits. They don’t do all these things consistently they sometimes fail, but so do other businesses.
>> We’re not talking about fiat money here, we’re talking about fiduciary
>> media.
>
> I am using the Mankiw definition here: money without intrinsic value.
“Intrinsic value” is a dicey idea. Some people say that an item of property has intrinsic value, but an paper contract such as a debt doesn’t. But, that all relies on the law and social conventions. If there’s a revolution then both property titles and debts may become meaningless.
>> Fiduciary media doesn’t create “false savings”. When you hold £1 in
>> your bank account you are loaning £1 to the bank and the bank is
>> loaning it to someone else. For every asset there is a matching
>> liability.
>
> That is really only an accounting relationship. It’s like saying 2 +
> 2 = 4. I know that you are aware that accountants can pull all sorts
> of tricks to make the books look good. The problem is that accounts
> are a derivative of reality; they are not reality itself.
I think this accounting relationship reflects reality. If a person has a current account with a balance of one ounce of gold then while they maintain that balance they are lending to the bank.
If that’s an accounting trick then why does it suddenly stop being an accounting trick when a time period is involved?
>> Banks don’t create fiat money, governments create fiat money. Banks
>> create fiduciary media. I agree with the rest of your little
>> summary of ABCT theory though.
>
> Just substitute “fiduciary media” for “fiat currency” and the result
> is the same.
I don’t have the time to go into much detail here, but I think the argument that free fractional reserve banks could create ABCT is wrong. It depends upon the banks being willing to create enough new fiduciary media in a relatively short time to raise prices. But, FRFBs wouldn’t have an interest in doing that. Steve Horwitz and George Selgin have explained why in their books.
> I intended this as a highly simplistic description of
> capital theory rather than ABCT although I appreciate it can easily
> be interpreted as such. My point is that that is no need for
> “fiduciary media” or banks “supplying money” in order for the
> economy to flourish. In fact, just the opposite is what the economy
> needs. The point is that individuals are the suppliers of capital
> (read: present goods) not banks, and this capital represents their
> real savings.
I agree that investment and growth can occur without FRB. But, I think that FRB is very important for enhancing growth. Without it’s invention the world wouldn’t be anything like as rich as it is today.
As Adam Smith wrote FRB provides a sort of “road in the air” that allows the ground below to be cultivated.
Think about it this way… If FRB had not been invented then all holdings of money would have to be specie. Holding money is a necessary economic activity, because of our lack of precise knowledge about the future, Mises explained. Once FRB was invented though holding money no longer meant investing in specie. It meant investing in a bank that invested in other businesses. That has helped ecnomic growth by enlarging the amount of funds available for investments and allowing gold to be find other uses.
>> “How would ABCT occur in a fractional-reserve free banking system?”
>
> It would be just like it is now with central banking but likely not
> as severe. The same fundamentals are in place: expansion of the
> money supply not backed by specie, artificially reduced interest
> rates, increased inflation, malinvestment etc.
How and why would free banks expand the money supply enough to artificially reduce the interest rate or create inflation?
> The best description of how this occurs in De Soto’s Money, Bank
> Credit and Economic Cycles, chapter 5. You can get a pdf online
> easily. In fact Current, if you get through the first five chapters
> of De Soto’s book and are still a free banker, I’ll buy you two
> pints of beer. How’s that for motivation?
I’ve read De Soto’s papers and I don’t find them convincing. For example, in his papers he answers the question I ask above by claiming that bank managers will behave recklessly. But he doesn’t really explain why.
I don’t intend to read his enormous book until I’ve got through many other enormous books first. Still, thanks for the offer.
>> As I pointed out above FR banks aren’t insolvent. In fact you
>> pointed that out too in your example of Continental Illinois bank.
>
> Continental Illinois was balance sheet solvent but cash-flow
> insolvent.
Yes. But, not all banks are cash-flow insolvent.
>> Well, all that really shows is that some depositors didn’t educate
>> themselves about what they were getting into.
>
> I know, what a bunch of fools! :-)
> Actually, I think the truth is more complicated. Before the
> mid-nineteenth century there wasn’t much legal support for
> fractional reserve banking (in the UK).
I don’t think that’s really true. Carr vs Carr established that bank balances are debts, which was just a continuation of earlier legal ideas on the subject.
> Also, a lot of bankers were very deceptive and/or secretive about
> what they were doing, hence the lawsuits.
Ok, what evidence would you give for this?
>> I would say that people are uneducated about this today because
>> deposit insurance means they don’t have to be educated. The >
>> government protects them so they don’t look into the details. And >
>> this is why people are uneducated about a lot of other things too.
>
> Do you think deposit insurance should be abolished?
Yes, absolutely.