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Friday, July 4, 2008

David Friedman on Fractional Reserve Banking

Dr. Friedman mentioned to me that he'd discussed this on Usenet before. Searching DejaNews (i.e. Google Groups) finds the following, mostly from 1998 on humanities.philosophy.objectivism.  This just scratches the surface, as it appears from this query that Friedman has about 14,000 postings archived on Usenet -- a veritable gold mine, so to speak.

I've read [Rothbard's] argument against fractional reserve banking (In "What Has the Government Done to Our Money," if I remember correctly), and discussed it with people who support his positions. It is wholly unconvincing, for two reasons:
1. It is not fraud to make a contract when you know there is some possibility you will be unable to fulfill it--if it were, essentially all contracts would be fraudulent.

2. It is certainly not fraud when you make it clear to your customers that there is some possibility you will be unable to fulfill it--as the Scottish banks (to take the obvious example--some of them had option clausies) did.

The notes are not receipts, they are promises to pay on demand. Under most circumstances the bank can fulfill those promises because although its reserves (i.e. the part of its assets held as gold, if that is the monetary metal) are less than the total of its notes outstanding, its assets are more.

Suppose the bank holds reserves of 20%. Customers bring in notes totalling 10% for redemption. The bank redeems them. It then sells some other assets and buys more gold. Repeat. The process continues until all notes have been redeemed.

There are two situations where this breaks down:

1. The bank is mismanaged, ends up with assets less than its liabilities, and goes bankrupt. That can happen to non-bank firms too. As I said, making a contract when you know there is some possibility you will be unable to fulfill it is not in itself fraudulent.

2. Customers bring notes in so fast that the bank doesn't have time to liquidate other assets and buy gold. The Scottish banks dealt with that (under a silver system) by an option clause--a term in the contract (I think actually printed on the banknote) specifying that the bank had the option of postponing payment (I think for a year, although I'm not sure), but then paying face value plus an interest penalty.

I think a system of private fractional reserve banking, preferably based on a market basket of commodities rather than a single metal, is a sensible way to produce money. A system of private fractional reserve banking based
on a monetary metal is an inferior, but also pretty good, way of doing it. A 100% reserve system is a relatively costly way of producing money, and as a result is unlikely to survive in a competitive market.

Rothbard wanted to reach a conclusion--that fractional reserve banking, private or public, ought to be prohibited. The reason he wanted to reach that conclusion, in my judgement, was that he thought fractional reserve banking had bad consequences--led to macro instability. But he was also committed to two other beliefs--that a free market worked very well without government intervention and that one could only legitimately ban activities if they involved force and fraud.

The only way he could make those beliefs consistent was to argue that fractional reserve banking involved either force or fraud, hence could be legitimately banned--whether by a government or in an anarchist society. But fractional reserve banking does not, in general, involve either force or fraud. Hence the need to fudge up a moral argument--to pretend that fractional reserve banking was inherently fraudulent.

I don't think government banking deceives the depositors as such--they believe, correctly, that they will almost always be able to go to the bank where they have deposits and get pieces of green paper in exchange.  The whole system "deceives" the public as a whole, in the sense of being based on what I think are false claims--but then, most of the people making those claims believe them, which makes it error, not fraud.

The three obvious solutions [for the problem of cascading bank failures] are:
1. For the bank to start with assets substantially greater than its liabilities, so that even after the assets are substantially reduced the bank will still be solvent. That was the Scottish solution--banks were unlimited liability partnerships, and the partners were wealthy.

2. For a bank to hedge against changes in the value of the monetary commodity, due to bank runs or anything else. It can hedge on the futures market, or it can hedge by holding assets whose price correlates with the price of the monetary commodity, such as stock in gold mines.

3. To use a monetary commodity whose monetary demand is very small compared to the non-monetary demand, so that the change in monetary demand due to a run on the bank, as Reisman describes it, has a negligable effect on its price. That was part of the point I was making in an early post, about why a market basket of major commodities was a better monetary standard than gold.

1. [Rothbard's arguments] don't apply to the current banking system, because deposits are redeemable in pieces of green paper, and the banks have a friend with a printing press.

2. Think about the logic of fractional reserve banking. A bank starts with a thousand ounces of gold and prints up five thousand "one ounce" bank notes--promises to pay one ounce of gold on demand. It then uses those ounces to buy things--claims to future payment if it makes loans, or alternatively land, stocks, bonds, whatever. So its assets, assuming it isn't stupid about what it buys, start out at six thousand ounces--one thousand ounces in gold, five thousand ounces worth of whatever it bought with its notes. Its liabilities start out at five thousand ounces--claims against it by the holders of its note. Net assets are 1000 ounces after it issues its notes, just as they were before (neglecting the cost of printing up the notes etc.).

So for a bank to have assets to cover its liabilities is the normal situation. It is only when something goes wrong--the treasurer absconds, or the bank makes bad investments, or the like--that a fractional reserve bank becomes insolvent. And other firms can become insolvent under just the same circumstances.

Incidentally, the idea of private fractional reserve banking is not an obscure possibility, at least not for an economist with any interest in the history of his field. Adam Smith in the wealth of nations discusses banking at some length--and the system he was discussing was a system of private fractional reserve banks. So when Rothbard says that "FRB, therefore, are inherently inflationary institutions" and "If fraud is to be proscribed in a free society, then fractional reserve banking would have to meet the same fate" he isn't just talking about government banks.

Roosevelt engaged in force, not fraud, when he banned private ownership of gold. I think the secretary of the Treasury routinely engages in fraud in the process of trying to persuade private citizens to buy government bonds--indeed, I suspect that many of the statements made by the government would be actionable if made by a private firm selling its securities. Inflation would be fraudulent if the people responsible announced that they were going to be following policies that would lead to stable prices when they knew it wasn't true.

Gold is used for both monetary purposes--coinage and reserves--and non-monetary purposes, such as electrical contacts and filling teeth and making jewelery. Suppose that, at a particular price level, 90% of the gold is used for non-monetary purposes and 10% for monetary uses. For some reason, people shift from coins to (fractional reserve) notes, and the banks manage to maintain the redeemability of their notes with only a very small fraction of their assets held as reserves, so the amount of gold used for monetary purposes falls tenfold--a huge shift. Total quantity demanded of gold, however, has fallen only from 100% of its previous value to 91%. Since demand is now below supply (more precisely, quantity demanded < quantity supplied), the price of gold falls--meaning that the
price level rises. It doesn't have to fall very far, however, before the increase in quantity demanded as a result of the fall in price brings quantity demanded up to quantity supplied (which, of course, may decline a little as the price of gold, the amount of other things you can get in exchange for an ounce of gold, falls).
Now redo the analysis, starting with 90% of the gold used for monetary purposes, 10% for non-monetary. The same change in the monetary system results in a much bigger change in the price level.
Finally, suppose your "reserve commodity" is a basket of goods--in exchange for a million banknotes, you can have a ton of steel, plus a hundred barrels of oil, plus 500 bushels of wheat, plus ...--all, of course, of contractually specified quality. Just as with a gold standard, the result is a quantity of money such that the basket is worth almost
precisely a million banknotes. But practically none of the world's steel, oil, etc. is actually being held by banks as reserves, so monetary demand for the reserve commodity has a negligable effect on total demand for it, so changes in the monetary system have very little effect on prices.

With a fiat currency, the quantity is regulated by the issuer. With a fractional reserve currency that functions with a small reserve ratio, the quantity is regulated by the market. If there is too much currency--i.e. a quantity at which the market price of the reserve commodity is higher than its monetary price, people turn in banknotes for the reserve commodity, driving down the money supply. If there is too little currency, issuers find they can print more and it doesn't come back to them for reserves. So you end up with just the quantity of money that produces a price level at
which the market price of the reserve commodity equals its monetary price--an ounce of gold sells for a "one ounce banknote" if gold is the reserve commodity.

I was referring to was a real institution--the Scottish banknotes of the 18th century -- a historical example of private fractional reserve money. And since everyone knew that the option clause was only rarely exercised, they in fact circulated as money--were, indeed, the usual money of Scotland at the time. And, of course, the macro arguments about the bad consequences of fractional reserve money which, in my judgement, motivated Rothbard to this particular bit of sophistry, would apply to those notes just as to ones without the option clause--which eliminates the whole point of the argument.
Do you regard all airline tickets as fraudulent? Airlines routinely overbook, allowing for the fact that some people with reservations won't show up--and, if everyone shows up, they offer compensation to people willing to be switched to a later flight. They cannot know for certain that anyone will accept their offer. So they are selling a ticket knowing there is some chance they will be unable to deliver. Is it still fraud if they tell everyone who buys tickets about their overbooking policy?
What if they didn't overbook? There is still some probability that mechanical failure will leave them without an airplane.
Fraud doesn't consist of making a contract that you know there is some small probability you will be unable to fulfill. It consists of deliberately misleading the other party as to the circumstances of the contract.