Fractional reserve banking

"From a legal point of view what fractional reserve banks do is they create multiple owners of the same piece of property. If you have two owners who at the same time claim to be the exclusive owner of one piece of property, conflicts must arise. These conflicts become revealed in a bank run, when not everybody can be paid but whoever comes first is paid, whoever comes later is not paid at all. The same is true for fractional reserve banking under a fiat currency, where more paper money is loaned out than has been deposited."

This isn't correct. There is only one owner, he has simply contracted his property out for interest. However the lender may "call" the loan and accrued interest at any time unless the bank invokes their contracted option of suspending payment temporarily. This contractual arrangement can prevent "runs" on the bank.

angurse wrote:
This isn't correct. There is only one owner, he has simply contracted his property out for interest. However the lender may "call" the loan and accrued interest at any time unless the bank invokes their contracted option of suspending payment temporarily. This contractual arrangement can prevent "runs" on the bank.

Is the quote from de Soto's book by any chance? He seems to believe that fractional reserve banking mainly revolves around fraud, which it doesn't have to. Although he does give good historical information.

Do banks in practice actually have contractual clauses that allow them to suspend payments for demand deposits?

There are only two problems with fractional reserve banking:
1) There exists almost no market mechanisms or incentives to stop banks from doing this. This is because fiat currencies have legal tender. If anybody could make their own currency and back it with anything they wanted, then a system of free banking (where for example, each bank or groups of banks had currency unions) would ensure that consumers fairly quickly switch to currencies that are not losing value through fractional reserve banking. Thus, not only do banks hold the risk of becoming insolvent, but they also stand to lose customers in the short run. No business or consumer will continue to use a currency suffering from inflation when they have a choice to switch to one that is not. Just as people substitute one product for another when prices rise too much.
2) The moral hazard of a central bank which intends to bailout anyone with political connections. This makes private the gains of highly leveraged banks during the short run, and public the losses they incur in the long run.

Then of course, having created this absurd system of incentives, governments try to stop the consequences through regulation, which destroy business...

Solreyus wrote:Do banks in practice actually have contractual clauses that allow them to suspend payments for demand deposits?

I can't speak for all, I know some do.

Solreyus wrote:1) There exists almost no market mechanisms or incentives to stop banks from doing this. This is because fiat currencies have legal tender. If anybody could make their own currency and back it with anything they wanted, then a system of free banking (where for example, each bank or groups of banks had currency unions) would ensure that consumers fairly quickly switch to currencies that are not losing value through fractional reserve banking. Thus, not only do banks hold the risk of becoming insolvent, but they also stand to lose customers in the short run. No business or consumer will continue to use a currency suffering from inflation when they have a choice to switch to one that is not. Just as people substitute one product for another when prices rise too much.

I think you've answered your own concern. Knowing that consumers will switch currencies at the sight of insolvency/inflation the banks have an incentive to find an optimal reserve rate to ensure payments, thus keeping the consumers satisfied.

Solreyus wrote:2) The moral hazard of a central bank which intends to bailout anyone with political connections. This makes private the gains of highly leveraged banks during the short run, and public the losses they incur in the long run.

Then of course, having created this absurd system of incentives, governments try to stop the consequences through regulation, which destroy business...

Of course, a central bank isn't necessary for fractional reserve banking and couldn't exist in a system of free banking.

angurse wrote:
I can't speak for all, I know some do.

That's interesting, I wonder if people realise this.

angurse wrote:
I think you've answered your own concern. Knowing that consumers will switch currencies at the sight of insolvency/inflation the banks have an incentive to find an optimal reserve rate to ensure payments, thus keeping the consumers satisfied.

Ah, but the wonderful thing is that there is no "optimal" reserve rate to avoid inflation. The moment a bank begins to expand credit, and let us propose that this bank has its own currency, then inflation would inevitably follow suit. True, the bank won't necessarily become insolvent, but inflation would most certainly occur. The result? With competing currencies, the tiniest amount of credit expansion causes inflation, and sends consumers away to other currencies. There's a reason why national, collectivist, "public" ownership of currencies is advocated by those banks which practice fractional reserve banking.

As a pernicious side effect, it also creates the incentive that those banks that do not expand credit, suffer in the collective inflation of those that do. And so one could quite simply construct a game theory table demonstrating how banks themselves have the incentive to expand credit, even if they had some moral constraints, just in order to be as profitable as their competitors.

Solreyus wrote:
Ah, but the wonderful thing is that there is no "optimal" reserve rate to avoid inflation. The moment a bank begins to expand credit, and let us propose that this bank has its own currency, then inflation would inevitably follow suit. True, the bank won't necessarily become insolvent, but inflation would most certainly occur. The result? With competing currencies, the tiniest amount of credit expansion causes inflation, and sends consumers away to other currencies. There's a reason why national, collectivist, "public" ownership of currencies is advocated by those banks which practice fractional reserve banking.

The optimal rate wouldn't be a static, fixed rate it would be ever changing. It would be the rate that correctly corresponds to the consumer demand for short-term loans. As long as the money isn't lent out beyond the demand inflation won't occur.

Solreyus wrote:As a pernicious side effect, it also creates the incentive that those banks that do not expand credit, suffer in the collective inflation of those that do. And so one could quite simply construct a game theory table demonstrating how banks themselves have the incentive to expand credit, even if they had some moral constraints, just in order to be as profitable as their competitors.

That side effect counters your prior claim, "With competing currencies, the tiniest amount of credit expansion causes inflation, and sends consumers away to other currencies." Banks that lend beyond the demand will see their notes trade at sub-levels and customers will move to a non-inflationary competitor. Banks only have an incentive to expand credit within demand, banks that go further will quickly find themselves out of business.

angurse wrote:
The optimal rate wouldn't be a static, fixed rate it would be ever changing. It would be the rate that correctly corresponds to the consumer demand for short-term loans. As long as the money isn't lent out beyond the demand inflation won't occur.

I think you're making a grave error here. In a fractional reserve banking system, money is never lent out beyond demand, because money is only created when bank clients demand it as debt. I think this is a Keynesian fallacy, though i'm not sure. But according to this theory, there are no monetary reasons for inflation in a fractional reserve system.

In reality, what happens is that interest rates are brought down by the central bank, consumers and investors then flock to their banks to borrow more at this lower rate, and banks create a new supply equal to the demand for loans. Theoretically, supply and demand for money are equal here. But what actually matters is the relationship of demand for goods and their supply. We're looking at a demand for money, and hence goods, rise; while the supply doesn't rise in tandem - more money chasing the same quantity of goods. The purchasing power of money is decided by its relationship to the quantity of goods in an economy.

angurse wrote:
That side effect counters your prior claim, "With competing currencies, the tiniest amount of credit expansion causes inflation, and sends consumers away to other currencies." Banks that lend beyond the demand will see their notes trade at sub-levels and customers will move to a non-inflationary competitor. Banks only have an incentive to expand credit within demand, banks that go further will quickly find themselves out of business.

I think you've misunderstood me. I'm distinguishing between two cases:

1. Currency is communal. All banks must use one national currency due to legal tender laws. Hence, any one bank creating more money will cause inflation for all other banks, even if they do not create more money. Hence, the profits of creating credit are private to the bank practicing fractional reserve banking; while the inflation is spread out amongst all banks.

2. Currency is individual to every bank, thus if bank A inflates, only the currency that bank A uses will be depreciated. Bank B and its own currency will not be affected.

Solreyus wrote:
I think you're making a grave error here. In a fractional reserve banking system, money is never lent out beyond demand, because money is only created when bank clients demand it as debt. I think this is a Keynesian fallacy, though i'm not sure. But according to this theory, there are no monetary reasons for inflation in a fractional reserve system.

In reality, what happens is that interest rates are brought down by the central bank, consumers and investors then flock to their banks to borrow more at this lower rate, and banks create a new supply equal to the demand for loans. Theoretically, supply and demand for money are equal here. But what actually matters is the relationship of demand for goods and their supply. We're looking at a demand for money, and hence goods, rise; while the supply doesn't rise in tandem - more money chasing the same quantity of goods. The purchasing power of money is decided by its relationship to the quantity of goods in an economy.

Perhaps I was speaking too short-handedly. The reserve ratio is a tool in determining the interest rate, a rate set too low (i.e. not corresponding to actual demand) will lead to consumers and investors taking more short-term loans (beyond actual demand). Ex ante is what is important, not ex post.

Solreyus wrote:1. Currency is communal. All banks must use one national currency due to legal tender laws. Hence, any one bank creating more money will cause inflation for all other banks, even if they do not create more money. Hence, the profits of creating credit are private to the bank practicing fractional reserve banking; while the inflation is spread out amongst all banks.

2. Currency is individual to every bank, thus if bank A inflates, only the currency that bank A uses will be depreciated. Bank B and its own currency will not be affected.

Yes, going with option 2 (free banking) counters the side-effect of FRB you mentioned prior.

angurse wrote:
Perhaps I was speaking too short-handedly. The reserve ratio is a tool in determining the interest rate, a rate set too low (i.e. not corresponding to actual demand) will lead to consumers and investors taking more short-term loans (beyond actual demand). Ex ante is what is important, not ex post.

I don't understand how consumers and investors are taking loans beyond demand. Surely the lower interest rate is what has just induced them to increase their demand given the cheapness of credit.

Maybe you mean that this doesn't correspond to sustainable demand for credit?

angurse wrote:
Yes, going with option 2 (free banking) counters the side-effect of FRB you mentioned prior.

Oh, I know that. I thought you were trying to tell me I was being inconsistent

In any case, the greatest problem that comes from credit expansion is not price inflation, but the misrepresentation of inter-temporal preferences and the resulting discombobulation of the capital structure. The boom and bust cycle is far more grave than price inflation, at least when it occurs without price controls.

Solreyus wrote:
I don't understand how consumers and investors are taking loans beyond demand. Surely the lower interest rate is what has just induced them to increase their demand given the cheapness of credit.

Yes, the lower interest rate is what leads them to taking loans when they otherwise wouldn't have. And, of course, the interest rate is determined by the reserve ratio.

Solreyus wrote:Maybe you mean that this doesn't correspond to sustainable demand for credit?

Ultimately sure, hence, "Ex ante is what is important, not ex post"

Solreyus wrote:
Oh, I know that. I thought you were trying to tell me I was being inconsistent

No, no, just making sure we don't throw FRB out with central banking. They aren't inseparable.

Solreyus wrote:In any case, the greatest problem that comes from credit expansion is not price inflation, but the misrepresentation of inter-temporal preferences and the resulting discombobulation of the capital structure. The boom and bust cycle is far more grave than price inflation, at least when it occurs without price controls.

It really isn't a problem within free banking, just as with inflation, the problems couldn't be nearly as wide-spread or devastating, and with careful management of the reserves and loan portfolios banks wouldn't expand credit too far at all.