Fractional Reserve Banking

joelkatz (60) in policits • 8 years ago (edited)

Is our banking system a "scam"?

This post is a response both to several of Ron Paul's arguments against fractional reserve banking and a series of tweets between David Andolfatto and I. I'll take his invitation and tell him, and everyone else, what I think informed citizens should think.

How the system works:

The way the banking system works is not a secret. Banks loan out their deposits. They use the interest they charge on these loans to pay interest to their depositors, to fund their operations, and to make a profit. Banks are required to retain assets that exceed their obligations.

Depositors cannot really lose money if a solvent bank encounters a liquidity crisis. So long as the bank is solvent, their capitalization can compensate depositors for the loss of use of their funds until loans are repaid. So long as the bank does not make too many bad loans, the depositors will be fine, even without insurance.

The arguments some Libertarians have made:

Some Libertarians have argued that all fractional reserve banking is inherently fraudulent and have even argued that any fair society would prohibit the practice entirely. This is nonsense. The system is not a secret. Anyone who does even a small amount of research can learn how banks work. The idea that two people who want to enter into a particular financial arrangement should be prohibited from doing so is entirely un-Libertarian.

Another argument is that fractional reserve banking is fraudulent in practice because banks don't disclose what they do with deposits when people open an account. This argument is, frankly, silly. When McDonald's sells a cup of coffee, they don't explain the precise risk of burns that it creates and what types of burns it can create with what type of exposure. Just as McDonald's can't include a medical education with a cup of coffee, banks can't include a financial education with every bank account.

Even in an ideal world, people wouldn't need to understand every detail of the contracts they enter into and the agreements they make. It's a common Libertarian objection to laws that we are all presumed to know them all, something that would be everyone's full time job were we to actually try to meet that presumption. The more a system can "just work" without people needing to understand how it does things the better, so long as that information isn't hidden from those who really do want to know. Those who wish to do so are free to distill this knowledge into convenient to digest form and provide it to anyone who wants to know more.

A more moderate position is that fractional reserve banking is a bad practice and that in an ideal society it would not exist. I've never found this argument persuasive. There exists a continuum from stuffing your money into a mattress to giving seed money to a new startup. It seems to be an inherent rule that greater returns are possible with, and only with, greater risk. Zero risk might be right for a few people some of the time, but I can't see how it would be the norm that most people would prefer most of the time. Fractional reserve banking seems to be a pretty good point on this continuum.

Fix only what's broken

I don't mean to argue that we have a perfect system and there's nothing we should change. If you've read my War on Cash series, you know that I am definitely not happy with many aspects of our financial system. But fractional reserve banking is not the problem.

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8 years ago by joelkatz (60)

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teamsteem (74) · 8 years ago

I'm not sure I understand the point you're making about fractional reserve banking.

On another note (pun intended) from what I understand, the current system of money creation really seems fundamentally flawed and partly because of FRB. Here's one quote from Maurice Allais the 1988 winner of the Nobel Memorial Prize in Economics which pretty much put the whole system into perspective.

"All money creation must be the prerogative of the state and the state alone: Any money creation other than that of the basic state-created currency should be prohibited in a way that eliminates the so-called 'rights' that have arisen around private bank creation of money.

In essence, the ex nihilo money creation practiced by the private banks is similar -- I do not hesitate to say this because it is important that people understand what is at stake here -- to the manufacture of currency by counterfeiters, who are justly punished by law. In practice both lead to the same result. The only difference is that those who benefit are not the same."

Addendum: the first sentence isn't as true anymore as cryptocurrencies exist nowadays. Also private entities could create their own money but not create national currencies. I just wanted to give some other perspective to your post.

Don't get me wrong this is just a simple quote and is in no way the full detailed care the topic should be treated with which I plan on doing in some coming posts.

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twitterbot (56) · 8 years ago

David Andolfatto tweeted @ 02 Oct 2016 - 13:57 UTC

@JoelKatz @RonPaul You tell me what informed citizens are supposed to think.

Disclaimer: I am just a bot trying to be helpful.

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jlufer (75) · 8 years ago

thank you very much excellent information

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stevescoins (68) · 8 years ago

So long as the bank does not make too many bad loans

that is a big IF

The entire bank crash issue in 2007-2008 was a direct result of intentionally made bad loans.

The U.S. Senate's Levin–Coburn Report concluded that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street.
https://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%9308

Congressmen wrote a law that "made" the banks give out ridiculously bad loans, with the foreknowledge that the taxpayers would take the risk. The banks bundled up these bad loans and used them as a commodity, again knowing they were taking no risk.

So the taxpayers bailed out some of the banks, and the congressmen got their baksheesh

fractional reserve banking is fraudulent in practice because banks don't disclose what they do with deposits

which is what exactly what happened

as long as the banks are underwritten by the taxpayer, the taxpayer has the fiduciary right to see every last cent on the account sheet.

In effect, I agree with you. It is not the banking system in itself that is a problem; It is the behavior of those in charge of the banks, and the politicians that allow those in charge of the banks to sandbag their own balance sheets for a taxpayer-funded profit.

Two immediately apparent fixes that should apply

First, all banks that are protected by taxpayer money must be fully transparent. If they want to make profit by taking confidential risks, they should move into the investment field, not the banking field.
Second, enact the death penalty for any public theft of more than 1 million dollars. The penalty would apply both to the banker that made intentionally bad loans, and to the politicians that facilitate such thievery with joke laws like the CRA

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ubg (58) · 8 years ago

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whaleshrew (25) · 8 years ago

The banks don't loan out their deposits, Katz. When you take out a loan they simply type in two debts in two accounts. One is the banks debt to you in your account (your "loan"), that can be collected through an ATM to get the cash. The other debts is your interest bearing debt to the bank. There's no relationship to other deposits.

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bitacer (55) · 8 years ago

Hi Joel,

when you have a chance please go ahead have a look at the link:
http://www.sciencedirect.com/science/article/pii/S1057521914001070

bye Joel.

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