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Saturday, May 23, 2009

The "Immorality" of Fractional Reserve Banking Revisited

Over at the Mises blog, there has been a heated discussion on the merits of free banking, meaning a system without a central bank where banks can (if they wish) lend out some portion of their demand deposits.

At several points in the thread, someone has said, in effect, "Fractional reserve demand deposits are inherently fraudulent, because there are circumstances (e.g., all depositors show up at once) in which the bank cannot fulfill its promise to pay on demand."

Let's accept this argument for a moment and see where it leads us.

First of all, life insurance can easily be seen as equally fraudulent. There are clearly circumstances (e.g., a nuclear war) in which too many people would die at one time for an insurance company to pay all of the claims coming in. In fact, after a little more thought, it seems all insurance is fraudulent, since the same is true of any insurance policy.

But, wait, as I follow this a little further, it strikes me that all financial futures contracts are fraudulent: you know, there's always the possibility that, say, the government might nationalize the oil supply, and the person who sold oil forward won't be able to deliver.

Now a great light is dawning upon me, and I see even more revealed! In fact, all business contracts whatsoever are fraudulent: they all involve the future, don't they, and so they all contain clauses that might not be fulfilled. And work for hire is clearly fraudulent if the employer doesn't fill the worker's bank account continuously as work progresses, since otherwise there is some possibility the wage won't be paid!

This is surely the mark of a fertile principle: from what we at first thought was an argument only rejecting a very particular business practice, we have managed, using only our original logic, to shut down the world economy!

11 comments:

  1. This is surely the mark of a fertile principle: from what we at first thought was an argument only rejecting a very particular business practice, we have managed, using only our original logic, to shut down the world economy!That's just how dangerous central banking is, Gene.

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  2. Gene,
    IF the bank you deposit your money in informs you that it will lend out x% of reserves, and as a result will not be able to return your deposits in case of a bank run, and you accept this condition, then fractional banking is NOT fraudulent.
    Equally, if an insurance company enters into its contract a clause according to which in the case of war, natural catastrophes on a regional/global/whatever relevant scale, it may not be able to honor its commitment, then this is not fraudulent, either.

    However, if your deposit banks lends out the reserves without the prior agreement of its depositors, then it is engaged in fraud.

    I have come across the comparison between insurance and fractional reserve banking before, and found it so astoundingly wrong that I pretty much ended the conversation at that point.

    Since you, however, are clearly quite steeped in economics, I realize that the confusion may be more commonly accepted than I thought.

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  3. Phillip Conti10:57 AM

    I suppose the difference is that we are all forced to use government money and we are all forced to subsidize the fdic insurance scheme. If there were no fdic, and if we could use other money if we prefer, then it really wouldnt be an issue.

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  4. "However, if your deposit banks lends out the reserves without the prior agreement of its depositors, then it is engaged in fraud."

    1) But, James, no bank has ever done this! No fractional reserve bank has EVER hidden the fact that it lends out reserves.

    2) James, I challenge you to present to me an insurance company that has put in a 'clause' stating that if they get really big claims they won't pay you.

    The charge of 'fraud' here is stupid beyond belief.

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  5. Just because it was always done this way does not make it right, especially if people don't know about it.

    And maybe they SHOULD state in their contracts that if total claims exceed the total funds available for the claim, they will not cover it - and then publish the volume of their funds.

    Not doing so should be considered fraudulent.

    Many things that are commonly accepted are not necessarily morally right.

    Maybe the implication is exactly this: if insurance companies do NOT state that, they are committing fraud. Not that because insurance companies don't do it, it becomes ok for others to act the same way.

    After all, just because the State collects taxes by force and w/o prior consent does not make the same action by a local mafia any more legitimate.

    By the way, some insurance companies do exactly that - state their maximum coverage. My travel insurance, for example, or my health insurance, or my car insurance. Maximum coverage...

    I also THINK that there are rating agencies (stop giggling now, it's a matter of principle....) that assess how capable these insurance companies are of meeting all the possible claims.

    And then there is Reinsurance.

    Insurance companies also don't cover war - unless you buy a war insurance, which is pretty much unaffordable.

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  6. Two objections
    1. The quantity. Imagine that I have being given ten free tickets for ten places in a theatre but I know that some people will not show up. So I might invite another four five telling them that there might be place available for them. But if I invite another 90 people I guess I might be asking for a messy outcome. [And fractional reserve banking is the legal right the banks have to lend money in excess of their reserves (even 90% in excess)]
    2. The quality. If I lend extra money (money not there) for productive investments the money will be there and so the bank customers could, in theory, receive vouchers linked to the investment. If I lend money for extravagant expenses or worse, the bank receives an interest but I, as a customer, get all the risk, even that of losing all my money. Ask the customers of Credit Suisse who saw their money given to Lehman Brothers (this in a huge quantity as allowed by fractional reserve banking). Perhaps the bank should bear 90% of the losses and the customers 10%. In that case I might reconsider fractional reserve banking.
    Sincerely
    Gian Piero de Bellis

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  7. Anonymous11:01 PM

    I don't mind if banks loan out money they have as long as this is understood by the customers.

    What's fraudulent is when they loan out money they DON'T have, which is what happens under a gold standard when banks loan in excess of reserves. It creates a bunch of fraudulent contracts that cannot be honored.

    If I knew my bank was doing that, I'd might as well just print up my own notes out of thin air and tell whoever I paid them with that they were backed by gold. There's absolutely no difference. It's a lie, plain and simple.

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  8. "If I knew my bank was doing that, I'd might as well just print up my own notes out of thin air and tell whoever I paid them with that they were backed by gold."

    IF you knew your bank was doing this?! Your bank IS doingt it!

    "There's absolutely no difference. It's a lie, plain and simple."

    Given that the information as to what fractional reserve banks do is available to any one who merely asks the banker, you must be using some new definition of lie.

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  9. The argument that people know exactly what banks are doing is at best highly disingenuous. I would estimate that 90%+ of people think that money on their checking account is available on demand at all times.

    Gene, since you believe the contrary, I guess you would have no problem in getting rid of FDIC insurance, the central bank, and legal tender laws? You really think fractional reserve banking would work under those circumstances?

    Also, the comment about insurance puzzles me; have you really never heard of force majeure clauses in contracts? They are ubiquitous in the finance and insurance worlds.

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  10. "The argument that people know exactly what banks are doing is at best highly disingenuous. I would estimate that 90%+ of people think that money on their checking account is available on demand at all times."

    But no one here made that argument, Bill! I said the information is not hidden. I was taught this in high school. If someone bothers to ask their banker, the banker will tell them. (And I like your empirical rigour there, Bill -- "I would estimate..." Beautiful!)

    "Gene, since you believe the contrary, I guess you would have no problem in getting rid of FDIC insurance, the central bank, and legal tender laws? You really think fractional reserve banking would work under those circumstances? "

    Hilarious! You really are not aware that there is a well-documented history of fractional reserve banking working fine without any of those legal institutions? Do you always pontificate on subjects you don't know a thing about?

    "Also, the comment about insurance puzzles me; have you really never heard of force majeure clauses in contracts?"

    Yes, in SOME circumstances the insurance companies don't have to pay out. Have you really never heard that 11 insurance companies went bankrupt due to Hurricane Andrew?

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  11. "The argument that people know exactly what banks are doing is at best highly disingenuous."

    I forgot to mention that I really appreciated that "highly disingenuous" bit as well. Even though you just made up the argument above and then implied that I made it, you still managed to call me a liar for using it!

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