Shortly after I published A Belated Reply on Fractional Reserve Banking, Jeff Molby inquired of me via email. I sent him a short response with the intent of responding more completely, here. There were a number of good comments/questions raised by other readers, and I do intend to respond to them, in turn. These things take time, however, so for now, you’ll have to content yourself with my response to Jeff.
Jeff writes:
I don’t support the status quo, but I wouldn’t support a society where 100% reserves are required by law, either. The reserve ratio should be negotiable between any individual and his prospective bank.
For instance, I should be free to contract with a hypothetical bank for an account with the following characteristics:
- I can withdraw my funds at any time
- The bank may loan up to 10% of my funds in any way it sees fit (or maybe it’s restricted in some mutually agreed upon way)
- I am responsible for any losses incurred on that 10%
- I am not charged any sort of warehouse feeSo basically, I would be accepting a certain amount of risk in lieu of warehouse fee and the bank is trying to turn a profit by using the 10% in an efficient way.
This may or may not be a standard position… I just never hear anyone talk about it.
I think this position is more common than you think, in fact it’s similar to the model of banking that most people (who are not bankers, financiers, or economists) believe that we have. And there’s absolutely nothing wrong with this model. However, there’s a huge difference between loan-brokering (which is what you’re describing) and fractional reserve banking. The problem is that the status quo is essentially licensed theft, and to the untrained eye it looks and sounds very much like the sort of thing you’re describing. It’s not.
Insisting on the ability to withdraw your funds at any time means that the bank would be in breach if they could not satisfy your withdrawal demand. The fact of the matter is that once you agree to permit the bank discretionary control over how that 10% of your money is allocated, it’s impossible for the bank to guarantee, or for you to insist, that you may withdraw your funds “at any time”. Any contract or agreement of this sort would be contradictory in nature: the second clause permits the violation of the first clause.
If you mark 10% of your deposits as “loans” and accept that they may be in default, then you are bearing the burden of risk and your investments may rise (or fall!) in value. Although in practice you may be able to withdraw the entirety of your balance at any time, this is not guaranteed, nor can it be. The only enforceable claim you would have is if the bank failed to honor your demand for the 90% of your money that they agreed not to loan.
If you really just want to loan money, why can’t you? For starters, as a central bank the Federal Reserve manipulates the money supply and the interest rates. Members of this cabal (for all intents and purposes, these members consist of all banks) are able to borrow money into existence, and lend it at interest. This privilege puts the individual lender at a severe disadvantage, it also hamstrings people who don’t make any loans or carry any debt (by decimating their savings)#:
Wage earners (most of us) are principally the last people to receive this newly created money, and they receive it only after enough time has passed and the primary and noticeable effects of inflation have rippled through the economy. If you wonder why prices rise, it’s because somewhere, someone else got access to a boat-load of newly minted greenbacks which nobody else knew existed (because in fact they did not exist) and used them to place competing bids on the purchases of real resources. — Fiat Credit Is Not a Loan (24 July, 2008)
Even still, until recently, individual lenders were able to find borrowers. But then the SEC banned interpersonal loans on sites like prosper.com which matched individual borrowers and lenders. (The SEC has since relaxed its ham-fisted ban on Prosper lending.)
Because of the auction-like nature of these loans, even with a modest sum like $500 or $1000, a lender could distribute his investments across multiple borrowers, mitigating default risk. In a truly free market, you wouldn’t need a bank to loan your money, you could do it yourself, and pay the warehousing fees for the rest of your money with your loan proceeds.
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Note: In another recent comment, the question of whether one has a “right” to purchasing power was raised. I do not intend to answer that question presently, although if it were answered in the affirmative, there could be no conceivable justification for fractional reserve banking.
I think we're still not quite on the same page, so let's take this a little further. Forget about the 90/10. All 100% of the funds that I hand over to the bank are a loan to the bank. It's a loan that I may revoke on demand.
With that mindset, it's pretty easy to see the bank is providing me with a number of valuable services:
– Qualifying borrowers
– Spreading the risk of individual defaults
– Allowing me to earn some amount of interest on my money w/o making a large dent in my liquidity
It goes without saying that the bank risks default in the case of a "run" or otherwise lacks enough liquidity to honor revocations, but that's no different than most businesses. The bank's assets would probably be listed as collateral on my loan to them, so you could handle the default just like any other bankruptcy.
Why not? It seems like what I described is a pretty accurate description of the system we had in 19th century America. We've added a bunch of other variables in the mix since then (Federal Reserve, FDIC, etc), but fractional reserve banking (the practice of lending out a portion of demand deposits) has been around for a few centuries.
I suppose the distinction that I haven't made explicit is that under the current system, and many others, banks lend out money that they don't currently hold as reserves. If they're going to grant loans backed by an actual reserve which may be lost in the case of default, they're creating money out of thin air, based on the belief that if called to redeem, they can use their depositors' funds because it's unlikely that a sufficient number of depositors will simultaneously demand redemption.
Forget about banks and cash. Forget about fiat money too; translate all of my units to ounces of silver if you don't like my use of the dollar sign. Consider this example.
John Doe owns nothing more than the shirt on his back. It's worth $1 on open market.
Joe Smith owns nothing.
Neither of them have any debts to anybody.
Doe's assets total $1.
Doe's liabilities total $0
Doe's equity is $1.
Smith's assets total $0.
Smith's liabilities total $0.
Smith's equity is $0.
The sum total of wealth in our example is $1.
For some reason, Doe decides to lend his shirt to Smith.
Doe's shirt asset drops to $0
Doe's accounts receivable asset increases to $1 (Smith is a nearly impeccable credit risk)
Doe's assets still total $1. ($0.99 if you really want to account for the tiny risk of default)
Doe's liabilities total $0
Doe's equity remains $1.
Smith's shirt asset increases to $1.
Smith's accounts payable liability increases to $1
Smith's equity remains $0.
The sum total of the assets in our example has increased to $2, but that is offset by the $1 increase in liabilities, so the sum total of wealth in our example remains $1.
This is all a legitimate and accurate accounting of reasonable human interaction.
Let's take it even further. Meet James Miller. He owns nothing, owes nothing. Net worth $0.
Smith lends the shirt to Miller.
Doe's shirt asset remains at $0
Doe's accounts receivable asset remains at $1
Doe's assets still total $1.
Doe's liabilities total $0
Doe's equity remains $1.
Smith's shirt asset drops to $0.
Smith's accounts receivable asset increases to $1
Smith's accounts payable liability remains $1
Smith's equity remains $0.
Miller's shirt asset increases to $1.
Miller's accounts payable liability increases to $1.
Miller's equity remains $0.
Aggregate assets total $3. Aggregate liabilities total $2. Aggregate wealth totals $1.
Again, this is all perfectly legitimate and accurate accounting.
The only question remaining is: is it legal for Smith to lend the shirt to Miller?
Now, Smith isn't merely storing the shirt on Doe's behalf; he has a legitimate ownership claim to the shirt that is limited only by terms of the loan. So assuming that Doe's loan doesn't explicitly restrict Smith's use of the shirt, it's absolutely legal.
It's probably stupid of him to do, though, especially if his loan from Doe states that he must give Doe an equivalent shirt on demand. So, maybe Smith decides to borrow shirts from Curtis, Lewis, Jackson, and Lee… all with the same terms. Maybe he holds onto two shirts that he wears as he goes about his daily life. The other three are on loan to others.
If you do all of the accounting using the same principles, you have a village with $5 worth of shirts, $8 worth of accounts receivable, $8 worth of accounts payable, and $5 worth of equity.
Now I don't happen to know why these people might have made the preceding transactions, but it's really not my place to worry about their motivations. As there were no fraudulent deceptions (i.e. Smith vows to retain possession of the physical shirt but doesn't), it's all legit.
When Doe initially lends Smith the shirt and says, "You can do whatever you'd like with my shirt provided that, when (whenever) I ask for it back, you are obliged to return it (or one quite similar to it), without hesitation or delay," doesn't this pretty much preclude Smith from re-lending the shirt?
Nothing is instantaneous, so there has to be some allowance for a good-faith transfer. Even if the shirt is on Smith's back, it takes him X seconds to remove it and hand it over. The length of the transfer allowance is certainly a limiting factor, but it doesn't completely preclude the re-lending because Smith could easily lend it to a neighbor, co-worker, or anyone else that Smith believes would be readily accessible in such a circumstance.
But all of that becomes far less important if the loan allows for equivalent shirts. After all, the shirt probably isn't a collector's item, so all Doe cares about is that he has a shirt that matches the relevant characteristics of the original shirt.
So if the loans all allow for equivalents and Smith has borrowed a total of 5 shirts, he may very well be confident that keeping two shirts on hand is sufficient to cover any likely revocations until he's had time to revoke the loans of the other 3.
It's a juggling game with inherent risks, but there's nothing inherently immoral about that as long as the terms of each loan are negotiated in good faith.
The gamble that Smith took in so doing, however, which now precludes him from honoring Doe's demand, was not a simple entrepreneurial risk. After all, the fact that Smith re-lends the shirt (on whatever terms) means that he has introduced an element of risk which impacts his ability to honor his obligation to Doe, and this variable was entirely within Smith's control to exclude from the equation.
By that logic, Smith wouldn't even be allowed to wear the shirt. After all, it is entirely within Smith's control to exclude the risk of ketchup stains from the equation.
If Doe's going to go around lending shirts has to realize that there's a risk that some of them won't come back in accordance with the terms. He's welcome to negotiate any terms that will reduce his exposure to a level he finds acceptable, but the bottom line is that Doe is only bound by the terms of the loan. In this example, we're presuming that the terms of the loan are fairly liberal.
I think the ketchup stain is reductio ad absurdum, primarily because this sort of accidental damage or loss is an insurable risk, whereas the other case is not. A ketchup stain, or a house fire, or a car accident are just those: accidents. They are undesirable situations which most people, most of the time, take reasonable precautions to avoid or prevent. When Smith lends out the borrowed shirt, he is on the contrary, inviting the very situation which he knows carries with it the possibility of default, and he is doing this because he believes he won't be caught. So, this is a situation he very much wants to be in. It's not a risk because he caused it, and in fact he wanted to cause it.
The probability of being caught may be low, in fact it may be almost zero. What I'm suggesting is that under these circumstances if Smith defaults, we can show A) that he caused the situation, B) that he wanted to cause the situation, and C) that there are no reasonable precautions he could've taken to eliminate the possibility of the undesirable (to Doe) outcome.
So, to your other point: if then Smith defaults because of a peril the risk of which Doe willingly accepted, then Doe doesn't really have a claim against Smith. It seems to me, and maybe I'm misunderstanding, that you want Smith to be liable for this class of risk, which in this case isn't really "risk" at all.
I don't understand the "accident" distinction. To be less absurd, let's assume smith got a new job working in a kitchen or a factory. His boss won't let him work without a shirt, so he borrows the shirt from Doe, knowing full well that he will be working in an environment where his shirt might get damaged. Maybe the terms of the loan compel him to insure against the risk, maybe they don't. Maybe he insures against it anyways, maybe he doesn't. It doesn't matter. It's up to Doe and Smith to decide mutually and/or individually how much risk they each want to assume.
It makes no difference whether Smith is working for someone or if he starts his own business. It makes no difference whether the business is in landscaping or lending. And yes, Smith can take reasonable precautions in a re-lending situation. He would presumably make the terms of his loan to Miller at least as restrictive as the loan from Doe to himself. He can insure against a possible default by Miller.
The bottom line is that there will be risks no matter how Smith decides to employ the shirt and virtually every risk can be mitigated.
That all depends on the terms of the loan. Doe will have whatever remedies are specified. He may find additional remedies in common law precedent.
Regardless, Smith accepts the risk that he will be subject to the various remedies if he defaults. Doe accepts the risk that he may have to settle for a remedy that is less valuable than the original shirt.
No, Doe can't have a claim against Smith, if Doe accepted the risk. Smith can't be liable for a risk that Doe accepted.
But we've digressed way, way, way off topic here. We keep coming back to these fictional scenarios where one party is legitimately lending something that he already owns, to another party, subject to whatever conditions upon which they mutually agree, and then we're nit-picking over what those agreements might or might not be.
The distinction that I'm trying to make is that if you oblige yourself to fulfill promises you are not prepared to keep, based solely on the assumption that you won't have to keep too many of them at any time, and in exchange for these promises you accept items of real economic value, then you have defrauded the other party in the exchange by entering into a no-interest contract.
"I don’t support the status quo, but I wouldn’t support a society where 100% reserves are required by law, either."
I find that to be an EXTREMELY disingenuous statement, even if it's not an outright lie. Who seriously would refuse to support a free society on the sole basis that it requires 100% reserves, and go back to living under authority?
My apologies, Francois, that wasn't how I intended it. If my only choice was between the status quo and an almost perfectly free society, I'd take the almost perfectly free society.