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More on fractional reserve banking.

Walter Block posts a response to my earlier post. He still says that borrowing money from a depositor is like selling a "square circle": it is a "logical contradiction." It's not, as long as the contract right is defined correctly.

A and C enter the following contract. A is to give C $100 and agrees that C may do various things with it -- lend it out, invest it, whatever. The contract provides further that A may demand cash up to $100 (never aggregating more than $100) from C at any time. C must satisfy the demand in cash to A if C has cash on hand; if not, C must liquidate his assets up to A's demand and pay the proceeds to A. If, even after liquidating his assets, C does not have enough to satisfy A's demand, he must pay what he has, and A's ability to satisfy his claim is contingent on C obtaining additional assets.

Block says that C is "bankrupt" the moment that he accepts A's cash and turns around and loans out part or all of it to another party, B. This is not true as a matter of law or economics. C's loan to B is worth something and appears as an asset on C's balance sheet. It's perfectly possible that if A demands his $100 back on day 2, C will be able to sell the loan and use the proceeds to pay back A and even make a profit.

Still, if Block is right, I'd think libertarians would be troubled by the thought of a vibrant market, going back many, many years, in square circles, involving millions of sophisticated people on both side of the transaction, endorsed by thousands of common law judges who are responsible for all our other precious contract and property rights. It's not a result of fraud in the sense of deceit, Block says (even though that is what fraud means). It is a kind of "fraud" where both parties, with full knowledge of a transaction that is internally contradictory, nonetheless decide to go through with it. If I offer to sell you a square circle, would you buy? With delusional behavior on such a grand scale, fractional banking would be the least of our problems.

byomtov (mail):
Why are you wasting time with this idiot?
11.9.2008 10:00pm
Charlie (Colorado) (mail):
What byomtov said.

Jeez, it's not that hard. When A deposits money in bank B, A acquires an asset: a receivable against B, B's obligation to repay. Since this is more risky than keeping the money in a mattress, B has to promise to pay A a premium; the longer A promises to let B use the money, the more premium B has to pay.

When B loans the money to C, B acquires an asset in return: C's obligation to pay, and sure enough, C has to pay a premium as well, which had better be more than B pays A.

But why is B paying A? Because there is additional risk. Why is C paying B? Because there is additional risk. What is risk? The product of the probability of a bad thing happening times the amount that can be lost. What's the bad thing? That B or C won't be able to pay.

The notion that there is some "fraud" involved is really just an indication of the failings of modern education.
11.9.2008 10:17pm
John (mail):
Block goes astray when he says:

"Consider this: A deposits 10 ounces of gold in B's bank; B gives A a demand deposit for these 10 ounces. B turns around and lends C 9 of these ounces, giving C a demand deposit for these 9 ounces. Thus, A and C both own full rights to these 9 ounces."

No banking transaction results in two people having a right to the same asset. In the hypothetical Block starts out with, claimants might have the right to have a bank deliver each of them some gold, but, unless there was a custodial agreement, there would be no right to a certain brick of gold.
11.9.2008 10:26pm
Dilan Esper (mail) (www):
1. It's obviously not fraud, for the simple reason that there is NEVER fraud when both parties to the transaction know what is going on. There must be both actual and reasonable reliance on a false statement by one party. There is no false statement by the bank and no reliance on it, or reasonable reliance (given everyone knows this is how banks work), in the transaction.

2. Given this fact, why do lots of goldbugs insist on calling it "fraud"? I have a theory. Most goldbugs are libertarians who believe in a very weak regulatory state. Banning fractional reserve banking would require a pretty intrusive regulation, essentially depriving citizens of any right to contract with another person to place their money in a common fund and then loan it out, paying a fee for the use of the money (interest).

Libertarians, who have a maximal belief in "freedom of contract", generally think that only two things justify state prohibition of particular types of contract-- force and fraud. Thus, there is no actual loss of liberty when the state refuses to enforce contracts made under duress, or even arrests the perpetrators. Similarly, it is not inconsistent with libertarianism to prevent fraud, as parties who are defrauded are not acting freely in consenting to a contract.

Thus, the "fraud" claim does work within the libertarian's own ideological preconceptions. If you are not a libertarian, the issue is just a banking regulation question of whether we should allow a certain banking practice. But if you are a libertarian, banking regulation is generally a no-no, so you have to justify the ban on fractional reserve banking as preventing a form of fraud. So that's why they stretch the definition of fraud to get there.
11.9.2008 10:34pm
Calculated Risk:
I also have to agree with what was said above. Why waste your time with this guy.

It is as if every contract that did not have 100% probability of performance -- that is any and all contracts involving future performance by one party or both parties -- were fraudulent.
11.9.2008 10:37pm
Mike Friedman (mail) (www):
Stop arguing with this loon.
11.9.2008 10:43pm
John W (mail):
Block's mistake is really simple:

He argues that the borrower has a "FULL" right to the gold/cash/whatever. That's not true. The borrower takes it from the bank along with an obligation to make repayment. (yes, the obligation isn't secured on the asset lent, but it could be secured on the borrower's other assets)-in any case, the problem is he's saying that the borrower, after borrowing money, is up 9 ounces of gold (in which case, we'd have nineteen ounces in the world. He's not-he's up 9 less the obligation he took on to repay, i.e. zero.

He also seems to think that the bank has an obligation to the borrower (other than lending the gold)--when claiming it can't satisfy its obligations at once.

Interestingly, if you look at the example he gives of a perfectly acceptable contract, it's exactly the same as borrowing from a bank-if we replace the widgets with dollars, and assume the seller is a middleman who gets widgets on credit from a manufacturer.

" In very sharp contrast, there are NO OTHER contracts quite like this in the economy. Yes, I buy 10 widgets from you for delivery today, in consideration for my promise to pay you $10, tomorrow. A day passes, and I am unable to carry out my part of the bargain. But, it is not a LOGICAL CONTRADICTION to suppose I am unable to do so, as in the case of frb."
11.9.2008 10:44pm
John W (mail):
Block's mistake is really simple:

He argues that the borrower has a "FULL" right to the gold/cash/whatever. That's not true. The borrower takes it from the bank along with an obligation to make repayment. (yes, the obligation isn't secured on the asset lent, but it could be secured on the borrower's other assets)-in any case, the problem is he's saying that the borrower, after borrowing money, is up 9 ounces of gold (in which case, we'd have nineteen ounces in the world. He's not-he's up 9 less the obligation he took on to repay, i.e. zero.

He also seems to think that the bank has an obligation to the borrower (other than lending the gold)--when claiming it can't satisfy its obligations at once.

Interestingly, if you look at the example he gives of a perfectly acceptable contract, it's exactly the same as borrowing from a bank-if we replace the widgets with dollars, and assume the seller is a middleman who gets widgets on credit from a manufacturer.

" In very sharp contrast, there are NO OTHER contracts quite like this in the economy. Yes, I buy 10 widgets from you for delivery today, in consideration for my promise to pay you $10, tomorrow. A day passes, and I am unable to carry out my part of the bargain. But, it is not a LOGICAL CONTRADICTION to suppose I am unable to do so, as in the case of frb."
11.9.2008 10:44pm
Soronel Haetir (mail):
I believe the actual problem that folks like Boch have is that FRB is guaranteed to fail at some point. Other contracts for future performance have a non-zero risk of non-performance, but the conditions can still be met for all parties. With FRB someone, somewhere is going to be left holding the bag.

In the above example of A depositing 10oz with B loaning 9oz to C, the interest has to come from somewhere. So I wonder if this is actually an argument against centeral banking rather than FRB itself.
11.9.2008 10:47pm
John W (mail):
"I believe the actual problem that folks like Boch have is that FRB is guaranteed to fail at some point. Other contracts for future performance have a non-zero risk of non-performance, but the conditions can still be met for all parties. With FRB someone, somewhere is going to be left holding the bag. "

Not true. In the simple (non-interest) example, I borrow 10 from A, lend 9 to C. It's only guaranteed to fail if there's no way to make it succeed.

But wait! It can work: C pays me back, and then I pay A back. all parties have met their conditions, no failure.

And in the interest example, we only have a problem if there's no other money in the economy. And even then, the problem isn't with the bank, but with C, who agreed to borrow 9 and pay back 10 while knowing perfectly well that he would only ever have 9. That would be guaranteed to fail whether it was the bank's own gold or a depositor's gold he borrowed.
11.9.2008 10:51pm
Cody (mail):
I find myself honestly shocked to see putatively libertarian commentators - like Block - argue so strongly against freedom of contract. (Block says he's in favour of contract rights if they are "compatible with reality", which is great little phrase.)

I hate to trot out the old "how can you call yourself a libertarian and say X" trope, but...well...
11.9.2008 10:52pm
Sagar:
Dilan Espar,

do you think the social security trust fund is a fraud?

(i am not supporting Block's argument above)
11.9.2008 10:54pm
Scrivener:
Dr. Block is a professor of economics and thinks that FRB is bad for economy for whatever economic reasons.

If he stopped at that there would be no discussion here at volokh.com; he would be arguing with economists about economics.

But he insists on attaching to FRB some bad word from a law dictionary (fraud, bankruptcy, etc.) to bolster his economic argument among economists where this name-calling may get some traction.

But, naturally, not being a lawyer, he fails at this name-calling among legal audience.
11.9.2008 10:59pm
Oren:
But he insists on attaching to FRB some bad word from a law dictionary (fraud, bankruptcy, etc.) to bolster his economic argument among economists where this name-calling may get some traction.
Or he's using fruad non-technically -- not every use of a word implies the precise technical definition.
11.9.2008 11:15pm
HoyaBlue:
And this is why no one takes Lew Rockwell and the Von Mises Institute seriously.

It's really tough to believe that this guy has a Ph.D. in economics from Columbia and an economics professorship.

There is such a thing as reading too much Ayn Rand.
11.9.2008 11:19pm
John W (mail):

Or he's using fruad non-technically -- not every use of a word implies the precise technical definition.


In that case, it's hard to get around the argument that there's full disclosure-fraud in the colloquial sense is to impossible if each party understands exactly what they're agreeing to, including relevant values.

However, here, Block contends that this would still be fraud even with full disclosure (in fact, that there is full disclosure and it's still fraud)


The bank would indeed NOT lie to a depositor about any such thing. But, lying is only sufficient for fraud, not necessary. There are other ways to commit fraud besides an outright lie. For example, it is fraudulent for a bank or anyone else to try to sell you a square circle, even if they do not lie about it. Why? Because there is no such thing as a square circle, and, in order to a contract to be a valid one, not only must both parties agree to it (neither lies to the other), but, also, the contract must be in accordance with REALITY, and "sales" of square circles clearly are not compatible with that consideration.
11.9.2008 11:22pm
Sagar:
when a square circle can't exist, how is selling one not fraud? (assuming the seller is aware of the fact)
11.9.2008 11:28pm
Scrivener:
"he's using fraud non-technically -- not every use of a word implies the precise technical definition."

Lawyers are more experienced than economists at discussing "what is fraud", not only from the technical standpoint (which does not matter much here) but across the board.
11.9.2008 11:31pm
subpatre (mail):
While many here bash Block, yet ignore the immediate reality that the principles he advocates are being borne out at this moment. The system failed, and we taxpayers are making up the paying off the fraud.

I don't necessarily agree with Block, but arguments should address the $770 billion (plus the $50 billion auto payoff, plus the bank 'investments', plus...) that taxpayers are paying. From that standpoint, it is fraud —the technical and legal meaning— committed on people.

Fact is the system failed; it did fail. Perpetrators are being 'rewarded' with government payola. To defend the status quo requires evidence that systemic failure is not assured or routine; and that partial failures can be repaired by contract, perhaps government enforced but not necessarily government repair.
11.9.2008 11:37pm
John W (mail):

when a square circle can't exist, how is selling one not fraud? (assuming the seller is aware of the fact)


If I know exactly what you're selling, and know it can't exist, and contract with you anyway, I may be an idiot, but i'm not being defrauded.
11.9.2008 11:38pm
Doc W (mail):
Well you know, I don't think most people look at depositing money in a bank as merely entering into a contract that says the bank has to pay you the money if you demand it. I think most people have the impression that they have deposited their money in a place of safekeeping, and their money is damn well supposed to be there whenever they want it--not the exact same greenbacks, necessarily, but the point is, I doubt most people look at a bank as an investment club. They look at it as a repository. At some level, most must realize the money is being lent out and so it can't all be waiting there. Most ordinary folk might be shocked to know how small the margin is.

Not all, and perhaps not many, libertarians would agree with Block that fractional reserve banking is inherently fraudulent. Let the buyer beware, and let contracts be free. The big problem with the banking system as it presently exists under the thumb of the feds is that it facilitates all sorts of screwing around with the money supply by our august economic court astrologers. Together with government pressure to make bad loans, this gives us credit bubbles that burst and get blamed falsely on the market, serving as excuses for even more destructive meddling in markets. If Obama really does want another "stimulus package," then he really is an economic loose cannon. Together with the Democratic-controlled Congress, he has a fair chance of pushing the country into a long depression--rather like FDR did, with Hoover's help.
11.9.2008 11:41pm
Ricardo (mail):
Fact is the system failed; it did fail. Perpetrators are being 'rewarded' with government payola.

Yes, but AIG and Lehman Brothers are not deposit-taking institutions which engage in fractional reserve banking in the strict sense of the term.

Yes, they took on short-term debt and invest in long-term assets but so does just about every major corporation in the world today. You can blame the crisis on "excess leverage" but then this involves a discussion of how much leverage is excessive rather than a digression on fractional reserve banking. If you want to ban all short-term borrowing on the grounds that some firms may not have the cash to meet their obligations without borrowing again, that's a return to the Dark Ages. I would have said Middle Ages but since merchants were already using short-term credit to finance their businesses by then, that's not really accurate.

A discussion of fractional reserve banking is perfectly appropriate if we are talking about the origins of the Great Depression in an era when many banks had only one branch and there was no deposit insurance. Today, the financial landscape is quite different and this business about supposed "fraud" in fractional reserve banking is an irrelevant distraction.
11.10.2008 12:01am
subpatre (mail):
Money as Debt by Paul Grignon. 45 minutes, 140 MBytes. Not always correct, but very provocative and well worth the time for non-economists.

Again. Defending the status quo is defending taxpayer subsidies to intentional misconduct. It doesn't support Block's position, but there's got to be better ways to run money markets or services than through massive tax supports.
11.10.2008 12:02am
Ricardo (mail):
Well you know, I don't think most people look at depositing money in a bank as merely entering into a contract that says the bank has to pay you the money if you demand it. I think most people have the impression that they have deposited their money in a place of safekeeping, and their money is damn well supposed to be there whenever they want it--not the exact same greenbacks, necessarily, but the point is, I doubt most people look at a bank as an investment club. They look at it as a repository. At some level, most must realize the money is being lent out and so it can't all be waiting there. Most ordinary folk might be shocked to know how small the margin is.

This is what safe deposit boxes are for. You pay the bank a service fee (rather than the bank paying you interest) and get guaranteed safe-keeping. The fact that more people don't do this is testament to how inefficient it is.

The big problem with the banking system as it presently exists under the thumb of the feds is that it facilitates all sorts of screwing around with the money supply by our august economic court astrologers. Together with government pressure to make bad loans, this gives us credit bubbles that burst and get blamed falsely on the market, serving as excuses for even more destructive meddling in markets.

Who at the Fed forced Lehman Brothers to make massive leveraged bets on mortgage-backed securities? Which Fed official told AIG it would be a brilliant idea for them to act as the counterparty to billions of dollars' worth of credit default swaps with minimal capital to back up their commitments?
11.10.2008 1:05am
Avatar (mail):
Ricardo,

Specifically, who forced them? It could be, just maybe, that a tremendous portion of the market is now managed in distributed funds with no underlying desire to invest in the companies involved, save that the asset price of their investment increases.

Assume for a moment that the market sets stock asset prices appropriately, which isn't always the case in reality. Then how is the company to increase its stock price? By increasing its performance - more market share, more sales growth, more profits. For a company's share price to increase, it has to do better than it did last quarter, regardless of how much better it did last quarter or the quarter before that.

Theoretically that's just possible. A company can continually innovate, continually expand into new markets, each quarter bigger and more important and growing faster than the last. Of course, theoretically you could go to the convenience store and win three scratch-off lottery tickets in a row. It's just... unlikely. So, too, is perpetual corporate growth.

The institutional investor doesn't care if company A is stable and doing well at its job. After all, the market price of A's stock reflects its stability. But they don't want stock price stability - they want increase. And that means company A can't just be stable. It has to try to increase profits by increasing sales, or decreasing costs, or entering new markets, otherwise its stock price won't increase - and most of its owners want nothing but that increase.

A lot of the things that company A might try can succeed. But a lot of them won't; they'll spend money to build a factory to produce a product nobody wants to buy, or they'll lay off people to cut costs and then wonder why their clients went elsewhere, or they'll try to do something in an entirely new industry and flop because nobody knew what they were doing and they didn't have the time to pay attention to what they were trying to do.

That's bad for company A, and thus the investors in company A. But for investors in general, it's good; companies in trouble provide depressed assets, which can be purchased for below-market value and provide the potential for easy growth. So it's in the market's advantage for there to be some churn, even if it's not in the companies' advantage. (Of course, if one of your competitors screws the pooch trying to boost third-quarter profits, I guess you win too...)

That's what's caused this to come to pass. It wasn't just lax regulation and government-sponsored bad loans. It was the entire financial sector being run by the stock ticker, forcing companies into ever-riskier investments to increase their profits, every time. (That's what was so good about these loans, right? They had the return of a risky investment, but there wasn't "really" any risk because they were backed by real estate, right? And real estate can't go down in value, right? Well, for a while that worked, and lots of stock prices went up...)
11.10.2008 1:37am
David Schwartz (mail):
Note that Block would prohibit all fractional reserve banking transaction, even with full disclosure, even with both sides fully understanding and fully willing to enter into the transaction. So whatever you might think of Block, he is no Libertarian.

I'm curious if he would prohibit all other contracts where extraordinary circumstances may cause non-performance. And if so, how probable does the non-performance have to be?

The fact is, fractional-reserve banking is a slightly risky transaction. However, everyone knows that with increased risk can come increased reward.

Block really wants to outlaw risk, which he crazily redefines as fraud even though both parties have no knowledge.

By the way, Block would be 100% right if FRB contracts involved an asset that was not fungible. But the error in his argument is precisely that FRB contracts are only ever made over fungible assets.

His square circle is completely comical. The point is, when an FRB contract is entered into, both sides know precisely what the other side will do. Unless the contract demands something that is literally impossible, WHICH IT DOES NOT, his square circle argument is nonsense.

I can promise to labor 25 hours a day for you, and so long as we agree on what will happen if I can't labor that much, there is no fraud.
11.10.2008 6:50am
DiverDan (mail):
When I read your first post on this, I found it hard to believe that any economist (much less one who calls himself a libertarian) could take the positions taken by Block. This time, when I saw the debate was continuing, I decided to take the time to read all of the original debate and the follow-up reply by Block. Sorry, Block just doesn't make any sense at all - even in the context which he claims, a discussion of normative legal battles. First, by insisting that a depositor retains (or, as a mormative matter, ought to retain) an ownership interest in the gold he has deposited in a bank in exchange for an interest-bearing demand deposit contract, Block either completely misses (or obtusely ignores) the essence of the transaction. A deposit into a bank is a sale -- I, the Depositor, am selling all of my rights in the property deposited (whether gold, siver, diamonds, or cash) to the Bank, and in exchange I am receiving a contract right to demand back from the Bank and equal amount in value, together with interest calculated over the time period between my deposit and my demand. As in any sale, the seller gives up all rights to the property sold. Would Block claim that a seller of a used car ought, as a normative matter, retain the right to control some or all aspects of how the car is used or disposed of by the buyer? Why would he find it preferable as a normative matter that a depositor retain more rights in the cash or specie sold in a deposit transaction than a used car seller would retain in the sale of a car?

I don't claim to be an economics professor, though my B.A. degree was in economics, and I do have an MBA. I am just amazed that someone as confused or obtuse as Block appears to be can obtain a Ph.D. in economics (legitimately, that is, and not from a "Degree for Fee" mill found on the internet), and I am really depressed at the thought that this guy might be actually teaching economics to an up and coming generation of economic illiterates.
11.10.2008 8:53am
John S. (mail):
The legal aspects of why Block's argument fails on the grounds of fraud have been well explained, so I won't go into that aspect any more.

But, I think the condemnation of fFRB as "bound to fail" is worth a bit more exploration. The practical implication of a bank lending is to create "commercial" money (as opposed to "federal", or hard, money created by the central bank.) That's correct, the bank pulls money out of thin air. When the loan is paid back, this commercial money disappears, right back into oblivion. I believe it is this concept that liberatarians and other gold bugs object to. And, FRB is a natuarlly inflationary system; left to its own devices, institutions have incentive to create way too much money by over-leveraging. This is why leverage ratios are tightly controlled for commercial banks; it effectively caps the money supply, and why rates have to be controlled by the fed. Without them, the system will collapse. Sounds scary, right?

The liberatarian argument is that gold, a fungible, tangible, difficult to create asset should back all money. The issue with this is that it implicitly assumes gold has a worth, which is only based in people's belief that gold has worth; after all, you can't eat, drink, or build with it. In this sense, replacing paper money with gold is no different than using paper money with a leverage ratio of near zero (the equivalent of how much gold can be mined in a given time.) The gold stardard isn't come magic panacea; it's just an excuse to get to a zero leverage ratio.

Now, one might logically ask, why not just go to a zero leverage ratio? The reason is that as opposed to frb's natural inclination to be inflationary, zero leverage tends to deflation. Growth is stunted in good times; in bad times, demands for repayment in gold directly contracts a countries money supply while debasing the value of that currency. Worse yet, the only option to correct this is for the government to intentionally spur inflation through defecit spending, or stop paying calls for gold.

The FDR argument so often made by liberatarians ignores one crucial fact: the reason the economy started to get better, and would have recovered on its own more quickly than without the New Deal, is the suspension of the gold standard. Foreign calls for gold were a fundamental reason why the crash of 1929 turned into a depression.

FRB is not perfect. It is subject to human errors, and these errors can compound into economic hardship. But at least the errors can be rectified. With the gold standard, the natural inclination is to trend to monetary contraction, which brings depression, which cannot be addressed by an economy on the gold standard; thus, the gold standard is, in truth, the system destined to fail. There is a very good reason the gold standard only existed for less than 100 years, before every country in the world abandoned it: It doesn't work!

(I have neglected in this argument the merits/problems with free banking, which I think would be the more natural choice for liberatarians, but which I rarely hear discussed. This is likely because Ron Paul, one of the least technically and scientifically savvy politicians I've ever heard supports the gold standard.)
11.10.2008 9:23am
Doc W (mail):
Block's particular version of libertarian philosophy is one thing, points of US &state law are something else, and economics is somehing else again. With regard to the latter, Block has more understanding in his little fingernail than anyone blogging here, I'm rather sure.

In a free market prices convey information about the availability of and demand for goods, services, equity, loanable funds, etc. The Fed warps that information when it jerks around with the money supply. That fact will not be gainsaid with rhetoric about how "nobody forced" such &such company to lend this or leverage that. A shift in incentives tends to result in a shift in behavior. When the Fed floods the market with easy money while banks are being pressured to make loans to people who are not likely to be able to pay them off, when mortgages are bought up by pseudo-government entities that everyone assumes (rightly as it turned out) will not be allowed to fail, an unsustainable bubble is generated. The bailout of Wall Street fat cats represents yet another shift in incentives, by the way, which is likely to produce even more counter-productive behavior.

The relevance of fractional reserve banking is that it is a central component of the government-manipulated system by which all this foolishness is carried on.
11.10.2008 9:36am
John S. (mail):
<blockquote>
Block has more understanding in his little fingernail than anyone blogging here, I'm rather sure.
</blockquote>

Formal education and understanding are very different. Einstein advocated quantum mechanics being incorrect until the day he died, but history has proved him wrong; no one would deny Einstein was a genius who contributed an enormous amount to physics, but that doesn't mean he understood everything about physics.

Just because Block has a knowledge of economics doesn't mean his ideas on FRB are correct, or even rationally defensible.
11.10.2008 9:43am
Reg (mail):
Why don't libertarians argue for free banking? I've never understood the connection between libertarianism and love of the gold standard.
11.10.2008 10:18am
Dilan Esper (mail) (www):
do you think the social security trust fund is a fraud?

No. I do think it is an outrage that we use it to cover up the true size of the deficit (something that Clinton stopped but Bush 43 started up again). Gore's "lockbox" is easily ridiculed; it is also a very good idea.

But political conditions ensure that Social Security trust fund, even though it is in reality an accounting fiction, will be honored. And Social Security is set up as a legal entitlement; yes, in theory, the government could later change the rules and cut the benefits, but in practice the seniors are powerful enough so that it would never happen.

It's not exactly what we would allow a private business to do, but the government is different and as long as political conditions remain the way they are with respect to old-age entitlements, I don't think anyone who puts money into Social Security has anything to worry about.
11.10.2008 11:17am
Dilan Esper (mail) (www):
The relevance of fractional reserve banking is that it is a central component of the government-manipulated system by which all this foolishness is carried on.

But the funny thing is that fractional reserve banking is a form of nonregulation, not regulation.

In other words, presumably the goldbugs would like a law saying that a bank cannot lend out money except for the exact term of a demand deposit, and cannot accept money for lending except in the form of a CD. That's a very onerous regulation. Indeed, it's essentially a 100 percent reserve requirement.

So we have the government saying instead that a bank can make any contract it wants to, as long as it maintains an X percent reserve, and that's held out as an example of government intrusion in the economy??????

Look, what is actually going on here is pretty simple. You have people holding two contradictory ideas in their head, the idea that regulation is bad and the idea that the government shouldn't allow banks to lend out money out of a common fund of deposits. The proper reaction to this would be to rethink one's commitment to libertarianism and admit that one favors some government regulation of the economy. Instead, we get the pretense that less onerous regulation of banks is in fact government manipulation.
11.10.2008 11:26am
DiverDan (mail):

And Social Security is set up as a legal entitlement; yes, in theory, the government could later change the rules and cut the benefits, but in practice the seniors are powerful enough so that it would never happen.


Will seniors still have the political muscle, or will, to prevent any changes to benefits when payroll taxes have to reach 40% or more just to fund current benefits? We are already depleting the Social Security "Trust Fund" fairly rapidly, as current benefit payments exceed payroll tax receipts (it's much worse for Medicare than the retirement fund, and Medicare will get worse as drug benefits increase). As medical progress leads to longer and longer lifespans, and Cost of Living Adjustments perpetually increase benefits payable, the growth in the population of seniors entitled to benefits and the growth of those benefits on an individual basis both assure that the program is mathematically unsustainable. Obama's proposal to coerce personal savings for retirement will be just another reason for working age voters to revolt. How long and hard will you work if you have to pay 40% of your earnings to FICA taxes to support current Social Security retirees, another 15% of your earnings into your own retirement fund (so you won't starve to death when Social Security goes bust), and, at a certain income level, another 30% to the Federal Government to pay for non-entitlement spending? I will bet that when too many workers are forced to live on only 15% of what they earn, they'll get mad enough to say to hell with the seniors.
11.10.2008 11:35am
byomtov (mail):
In the above example of A depositing 10oz with B loaning 9oz to C, the interest has to come from somewhere.

It comes from one of two places:

1) Profits generated because C has used the money for some productive purpose. C puts up a building, say, and rents out the space, etc.

2) C's other income. C may have used the loan for consumption, buying a car, for example, but has sufficient income to repay the loan over time. C has simply used the loan to shift consumption in time - a common practice the financial markets enable.
11.10.2008 11:44am
John W (mail):

It comes from one of two places:

1) Profits generated because C has used the money for some productive purpose. C puts up a building, say, and rents out the space, etc.

2) C's other income. C may have used the loan for consumption, buying a car, for example, but has sufficient income to repay the loan over time. C has simply used the loan to shift consumption in time - a common practice the financial markets enable.


And again, if C doesn't have the money to pay interest, that's not a failure of fractional reserve banking. It's a fraud by C, who is entering into a contract with no intention of performing-and equally bad if he borrows the bank's own money.
11.10.2008 12:11pm
Mark F. (mail):
It's a real fallacy to argue that because Block makes an error here, he knows nothing about economics. Do the Block critics think some economist is 100% correct all the time? Paul Krugman gets a hell of a lot more wrong than Block, despite his Nobel Prize.
11.10.2008 12:23pm
Soronel Haetir (mail):
C doesn't know going in that the loan is unrepayable. Having more players in the economy means that they can all operate in good faith yet someone will still get stuck with an obligation they can't meet.

I see the US Treasury/Fed relationship operating in much the same manner. Treasury issues bonds that are then put into circulation as money by the Fed, yet the debt obligation is larger than the circulating money so more bonds have to be issued in order to pay the debt. If we ever get to a point where people are unwilling to accept those bonds Treasury would be stuck, even if there were to be a 100% tax on all money.
11.10.2008 12:23pm
Doc W (mail):

Einstein advocated quantum mechanics being incorrect until the day he died, but history has proved him wrong

It would take us way off topic, and take more time than I can afford to spend, to tutor you about the sophistication of Einstein's concerns about the Copenhagen interpretation of quantum mechanics, concerns which in some respects have been vindicated.

Why don't libertarians argue for free banking? I've never understood the connection between libertarianism and love of the gold standard.

Some do advocate free banking. The origin of the use of precious metals as a widely accepted medium of exchange is probably shrouded in the mists of pre-history, but clearly it had to do with their scarcity, fungibility, and durability. If competing currencies were permitted in a free market, the likelihood is that they would be based in commodities.

What's so great about a gold standard, from a libertarian perspective? It means precisely that governments are constrained in their ability to create money out of thin air. They can't just monetize debt. Aside from eliminating a source of instability (Fed turning the spigot on &off), it actually forces the pols to get the money through highly visible taxes and make hard choices about what to spend it on.

As for Social Security, it's certainly the moral equivalent of fraud. People have been encouraged to think that their money is going into a trust fund, and they get "their money" backwhen they retire. What's actually going on, of course, is that each younger generation is simply being taxed to pay the bills of older retirees. Why not change this non-means-tested welfare system to a means-tested one for old folks who didn't or couldn't save enough for retirement? Because that would destroy the precious illusion that SS is some sort of "insurance" whose clients are anything other than welfare recipients.
11.10.2008 12:26pm
Mark F. (mail):
...I don't think anyone who puts money into Social Security has anything to worry about.

The check is in the mail

I'll respect you in the morning.

I'm from the government and I'm here to help.
11.10.2008 12:26pm
John W (mail):

C doesn't know going in that the loan is unrepayable. Having more players in the economy means that they can all operate in good faith yet someone will still get stuck with an obligation they can't meet.


Again, how is that in any way related to fractional reserve banking? If C knows he can't pay the loan back, he's defrauding the bank. If he doesn't know if he can pay it back, he's asking the bank to take a risk-which might be fine with disclosure, and a proper interest rate on the loan.

But that has nothing to do with whether C is borrowing the bank's own money (simple loan), or money A has deposited in the bank (fractional reserve banking). C's problem is exactly the same either way-and if there's any fault, it's on C.
11.10.2008 12:27pm
Doc W (mail):

You have people holding two contradictory ideas in their head, the idea that regulation is bad and the idea that the government shouldn't allow banks to lend out money out of a common fund of deposits.

Block can fend for himself. In general, libertarians view government meddling in the market as counterproductive and typically corrupt, and as a violation of individual rights. Of course, you can probably take almost any view and demand to push it until it becomes counter-productive itself, or self-destructs. Seems to me that as a practical matter, left-liberalism as a lot farther down that path than libertarianism. As far as I'm concerned, if people want to give their money to banks to lend out, so be it. I suspect Block would agree, as long as you don't call those particular institutions "banks."
11.10.2008 12:36pm
David Walser:
Block's objections to FRB are equally applicable to life insurance. Feelings Mutual sells a $100,000 insurance policy on each of the lives of 10,000 people. Unless Feelings Mutual collects a $100,000 premium for each policy sold, the company will not be able to meet its obligations under the policies (without recourse to other assets) if each of the 10,000 individuals insured were to die during the year. Does this make Feelings Mutual's life insurance policies fraudulent? No. The company's crack team of actuaries has assured the company that the premiums collected on the policies will allow it meet its obligations in virtually any imaginable circumstance. What if something really, really, unlikely happens -- like all 10,000 lives being lost as part of the Great Cholera Epidemic of 2009? In that case, Feelings Mutual may very well be unable to meet its obligations.

FRB entails the same kind of risks. Unless there is a run on the bank -- depositers asking for their money back at much higher rates than normal -- or unless borrowers default on their loans at much higher rates than normal, or some combination of the two, FRB works.

Block's argument would prevent not just FRB. It would prevent insurance as well.
11.10.2008 12:59pm
Laura S.:
Toy models => toy results => toy conclusions.

So, accept that there is a risk of default; thus there must be interest paid in real-terms. In the aggregate, given a fixed money supply, the entire loan portfolio cannot be fully unwound without loss given a positive nominal-rate of interest. Interest paid in real means that real-value of money must increase (which allows the nominal interest to be zero or even negative!) or there must be purchasing power constant seniorage. In general, there are an infinite number of seniorage-rate,interest-rate pairs that satisfy, but practical concerns: "wallet-cash" constrain these choices.

If the reserve limit is too low, the risk of default will be high which in turn requires a high-rate of real interest. Productivity growth is constrained. Ergo, the extent to which interest can be paid in real, not nominal terms is constrained. Ergo, the reserve fraction is constrained.

Trouble arises when the reserve fraction drifts too low. In practice, the reserve fraction is too low for the nominal-rate to be zero. The government makes up for this through seniorage, but this produces a curious result: under seniorage, nominal interest-rates should be elevated for the system-of-constrains to be satisfied; however, banks shun real-deposits (pay low interest rates). They do this because they are privileged to benefit from the seniorage. This is why saving-rates (quite rationally) are very low. People's saving reflects their settlement needs only. (Who invests via their checking account!)

Banks (private entities) benefit from seniorage (like a tax). People consider this to be unfair, but its hard to get rid of the seniorage without first reducing FRB.

It isn't fraud, but that doesn't mean that it is fair.
11.10.2008 1:33pm
Dilan Esper (mail) (www):
Will seniors still have the political muscle, or will, to prevent any changes to benefits when payroll taxes have to reach 40% or more just to fund current benefits?

Diver, with respect to the erosion of the political power of seniors, I'll believe it when I see it.
11.10.2008 1:41pm
byomtov (mail):
David Walser,

Good point about insurance.
11.10.2008 1:42pm
Dilan Esper (mail) (www):
If we ever get to a point where people are unwilling to accept those bonds Treasury would be stuck, even if there were to be a 100% tax on all money.

That's true, but (1) it's the role of fiscal and monetary policy to ensure that this doesn't happen, (2) this is a problem with any medium of exchange other than barter, i.e., if people stop accepting gold as a medium of payment, a gold standard economy would collapse, and (3) given the horrible economic consequences that we would have to endure to prevent the highly improbable risk of people not accepting US government credit, it isn't worth it.
11.10.2008 1:43pm
Dilan Esper (mail) (www):
If competing currencies were permitted in a free market, the likelihood is that they would be based in commodities.

1. No. Gresham's Law would indicate that "harder" currencies would be hoarded and "softer" currencies would circulate.

2. We actually do permit competing currencies in a free market, both in the form of commodities-backed securities and foreign currencies. The only thing you legally need dollars for is to pay taxes. And yet people prefer to accept fiat money.
11.10.2008 1:46pm
Dilan Esper (mail) (www):
Because that would destroy the precious illusion that SS is some sort of "insurance" whose clients are anything other than welfare recipients.

You are conflating two concepts. 1, that SS is some sort of "fraud" because you get paid back with the next generation's money. I answered that point above.

But your second concept is that SS is not "insurance". It certainly is insurance. When you buy insurance, and later have a loss, your loss is paid for out of other people's premiums.

Similarly, SS is government backed insurance against old-age poverty. Your loss is paid for out of the premiums of younger generations.

You are correct, however, about means-testing of SS being a political nonstarter because it might change the way people look at the program.
11.10.2008 1:49pm
Dilan Esper (mail) (www):
The check is in the mail. I'll respect you in the morning. I'm from the government and I'm here to help.

Libertarians are the type of people who see a government program which has worked perfectly well for 70 years and continue swearing that there's no way it can work.
11.10.2008 1:50pm
Dilan Esper (mail) (www):
As far as I'm concerned, if people want to give their money to banks to lend out, so be it. I suspect Block would agree, as long as you don't call those particular institutions "banks."

And how will changing their name (with a government regulation, by the way) change anything?
11.10.2008 1:51pm
Gabriel McCall (mail):
What makes Ponzi schemes immoral? It may be that a Ponzi is not fruadulent per se, as long as no representations are made that the scheme is anything other than what it is. And, a Ponzi is solvent as long as confidence remains high and investor money keeps coming into the scheme. The problem with Ponzis is that they are doomed to collapse the instant the money stops coming in.

Block's objection to FRB is, as I understand it, identical to the objections to Ponzi schemes: that there are always more claims outstanding against the system than there are assets with which to fulfill those claims, so a fractional reserve bank is doomed to failure if confidence in the bank falls enough to cause a run. And something strikes me as fundamentally unstable in that sort of business model.

But, arguing the other side, insurance companies (which are a staple of libertarian economics) are in exactly the same boat: No insurer has the funds to pay out all of its policies at once, and in the event of widespread catastrophe of the sort the company insures, the insurance company too is doomed to failure.

So, I guess my challenge to Posner would be to distinguish FRB from a pyramid scam, and to Block to distinguish FRB from an insurance company. I'm not convinced either way yet.
11.10.2008 2:31pm
Doc W (mail):

Gresham's Law would indicate that "harder" currencies would be hoarded and "softer" currencies would circulate.

Not if you can't get anybody to accept your peice of paper in exchange for goods. The fact that I could mimeograph (showing my age) a bunch of "Doc's Bucks" doesn't mean they would circulate.

We actually do permit competing currencies in a free market, both in the form of commodities-backed securities and foreign currencies.

Right, and that's why those folks who were issuing gold coins with Ron Paul's face on them got into a bunch of trouble and had their stuff confiscated. The fact that you can buy and sell (in dollars) commodity-backed securities does not mean that you can issue these as denominated currencies. As for foreign currencies, they're pretty much all fiat too.

As I pointed out earlier, Social Security's fraudulent quality stems from how people are misled by politicians into thinking that there really is something in that "Trust Fund" they paid into, that they get back in retirement. What there is, is the government's big gun and the politicians' willingness to use it to force people to pay up.

If I were to invest in a long-term private retirement plan, the funds are themselves invested at least to some degree in productive capital, the productivity of which is the basis for my enjoying a much higher retirement income than if I was simply drawing on an actuarial basis from the pile of bucks paid in. Social Security is not like that. It doesn't go into wealth-creating capital investment or even commodities. It gets spent by the pols.

The reality of SS is a non-means-tested welfare program for old folks paid for by a slightly regressive tax on young folks. If you want to call that "insurance," you've got a pretty weird concept of "insurance." And by the way, even where people are forced--and arguably properly so--to buy insurance, as for example car insurance, they have competing firms to purchase it from.
11.10.2008 2:35pm
John W (mail):

Block's objection to FRB is, as I understand it, identical to the objections to Ponzi schemes: that there are always more claims outstanding against the system than there are assets with which to fulfill those claims, so a fractional reserve bank is doomed to failure if confidence in the bank falls enough to cause a run.


Simply not true, and looking at it, the same argument of "multiple claims" on the same money applies to a deposit without lending-or a simple loan to someone directly. So if we really believe block's argument, ALL LENDING OF MONEY is "fraudulent" and "impossible".

Time 1: Depositor has $10, Bank has 0, Borrower has 0.
No problems here.

Depositor deposits.
D has 0 + a claim for 10, Ba has $10 and owes D 10, Bo has 0
According to block, there seem to be "two claims" on the $10 here? The bank has $10 dollars in bills, which it can use. Depositor has a claim on the $10.

But such an argument is crazy-it would apply to all lending:
Replace the bank with Libertarian Neighbor, and again, the depositor has a claim on $10, and LN has $10 in bills (to spend on developing a business), and an obligation to pay $10. Are there "two claims?"

Moving on, Borrower withdraws 9.
D has 0 and a claim for 10. Ba has 0, an obligation for 10, and a claim on 9. Bo has 9 and an obligation for 9.

Block says "Ah ha! Bo has a claim on 9, and D has a claim on 10. They each have a claim on 9 of the 10."

But the transaction between Ba and Bo is identical to that between D and Ba-in each, one party gives up cash and gets a claim, and the other takes on an obligation and gets cash.

Further, if we look at the state of the world, we find that each of Ba and Bo have taken offsetting positions-each has an asset and obligations that match-to give a net worth of 0. Hence, there is really only one "claim" on the money-and two "claims" of a right to use the money subject to repayment (effectively, they each hold interests junior to and subordinate to Depositor)
11.10.2008 2:42pm
Doc W (mail):

Libertarians are the type of people who see a government program which has worked perfectly well for 70 years and continue swearing that there's no way it can work.

It worked perfectly well, all right, for FDR and generations of politicians since, who have bamboozled the population about the time bomb they've set ticking. For the rest of us, it has made the economy less productive by diverting funds to the politicians instead of productive investments, it has deeply undermined the Constitutional limits on federal power, and it has amassed unfunded liabilities that probably can't be met.
11.10.2008 2:47pm
Dilan Esper (mail) (www):
What makes Ponzi schemes immoral? It may be that a Ponzi is not fruadulent per se, as long as no representations are made that the scheme is anything other than what it is.

Usually, a Ponzi scheme is accompanied by misrepresentations, and it is the misrepresentations that get prosecuted.

I would note that a NON-LIBERTARIAN could very well say that the nature of the Ponzi scheme is too risky and we need a paternalistic regulation to preclude people from taking an irrational risk. I have no problem with that argument. But libertarians normally assume that the market will provide better competing investment vehicles and the Ponzi schemes won't be successful, right?
11.10.2008 3:08pm
Dilan Esper (mail) (www):
Right, and that's why those folks who were issuing gold coins with Ron Paul's face on them got into a bunch of trouble and had their stuff confiscated.

You can't falsely claim something is legal tender which is not. However, you can exchange a gold-backed security or stock certificate or foreign currency for goods or services-- that is a perfectly legal transaction. And if people had no confidence in dollars, they would start doing so. But the fact is, the free market thinks dollars are fine. So erstwhile libertarians want to use government power to take away the people's choice.

The fact that you can buy and sell (in dollars) commodity-backed securities does not mean that you can issue these as denominated currencies.

That's right. You don't have the right to pretend that your commodity-backed securities are the same as federal reserve notes. You can, however, exchange them with anyone for goods and services if they are willing to accept them as payment.

The reality of SS is a non-means-tested welfare program for old folks paid for by a slightly regressive tax on young folks. If you want to call that "insurance," you've got a pretty weird concept of "insurance."

Really? Doesn't whole or universal life insurance work much the same way (i.e., accumulating a cash value paid to every policyholder while also paying a disproportionate amount to those who die young paid out of the pooled premiums)?

It worked perfectly well, all right, for FDR and generations of politicians since, who have bamboozled the population about the time bomb they've set ticking.

You guys have been claiming the time bomb was going to explode for 70 years. It hasn't yet. I wonder how many more decades do we have to go before you guys concede that maybe there wasn't a time bomb after all.

For the rest of us, it has made the economy less productive by diverting funds to the politicians instead of productive investments, it has deeply undermined the Constitutional limits on federal power, and it has amassed unfunded liabilities that probably can't be met.

1. That economy was sure unproductive in the 1950's, or the 1960's, or the 1980's, or the 1990's, or the last 8 years. It's horrible how we became the richest country on earth while having a Social Security program.

2. Of all the programs you might claim as an abuse of the commerce power, Social Security seems a strange one to me. It's a system of transfer payments with little regulatory effect on the economy.

3. Those unfunded liabilities can be easily met until 2070 or so with slight changes to the benefit formula. If you want to discuss Medicare, that's a different issue, but Social Security is very close to being solvent.
11.10.2008 3:16pm
Laura S.:

You guys have been claiming the time bomb was going to explode for 70 years. It hasn't yet. I wonder how many more decades do we have to go before you guys concede that maybe there wasn't a time bomb after all.

What? The "timebomb" exploded in the 1930s and the 1970s in the US. Etc, etc.
11.10.2008 3:40pm
byomtov (mail):
The problem with Ponzis is that they are doomed to collapse the instant the money stops coming in.

Yes. But banks aren't. They can operate just fine without increases in deposits.

Block's objection to FRB is, as I understand it, identical to the objections to Ponzi schemes: that there are always more claims outstanding against the system than there are assets with which to fulfill those claims, so a fractional reserve bank is doomed to failure if confidence in the bank falls enough to cause a run.

But there are not more claims than assets. You are confusing assets with cash. There will not be enough cash to meet the claims, but there will be, (or should be - banks can be mismanaged like any other business) enough assets to satisfy the claims.

Part of these assets consists of the loans the bank has outstanding. They are created when the loan is made. They replace, on the balance sheet, the cash that was loaned out. This is critical to understand. The money owed to the bank is a bank asset just like your checking account - money the bank owes you - is one of your assets. There are also other bank assets - buildings, etc. The bank's total assets far exceed depositors' claims. The excess is bank capital - money originally contributed by investors, accumulated profits, etc. So there are more than enough assets to meet the claims.

The difficulty in a run is the shortage of cash. A sound bank becomes illiquid, not insolvent. Think of a homeowner who suddenly, for some reason, has to pay off the whole balance due on his mortgage. He may have the assets to do this - the house - but not the cash. So the solution is to sell the house or, more likely, refinance - use it as collateral for a new loan to pay off the old one.

Similarly, the bank may be able to sell assets to meet demands for cash, but more likely it will borrow against them, either from another bank or from "the lender of last resort," which in the US will be the Federal Reserve.
11.10.2008 4:04pm
JBL:
Question:

Does the historical record support the claim that a gold standard and the elimination of fractional reserve banking will stabilize the effective money supply, discourage mispricing of assets, or encourage more productive investment?
11.10.2008 4:25pm
Dilan Esper (mail) (www):
What? The "timebomb" exploded in the 1930s and the 1970s in the US. Etc, etc.

Laura, the timebomb the earlier poster was referring to was Social Security. Libertarians keep on swearing that it can't work and it will go bankrupt; it never does, and they keep on reiterating their claims.
11.10.2008 4:28pm
Dilan Esper (mail) (www):
Does the historical record support the claim that a gold standard and the elimination of fractional reserve banking will stabilize the effective money supply, discourage mispricing of assets, or encourage more productive investment?

At least as to the gold standard, no. We had tons of panics and depressions during periods when the currency was backed by gold. They were longer and deeper than typical recessions since we have gone off the gold standard.

As for fractional reserve banking, I am not aware of any industrialized society that prohibited banks from having demand deposits and funding loans out of those deposits (though people have mucked with reserve ratios and at some point only states regulated banks). Theoretically, though, eliminating fractional reserve banking would eliminate the money multiplier (resulting in a severe depression) and would eliminate the ability of the central bank to do countercyclical monetary policy (which would have the same result as going to a gold standard-- less growth, bad deflation, and longer and more severe panics).
11.10.2008 4:34pm
ReaderY:
The term "fraud" simply isn't being used in a legal sense. It would be silly and of no service to mathematics for a mathematician to take Google.com to task for not really being a google in size. Same here for law.
11.10.2008 4:54pm
Doc W (mail):

You can't falsely claim something is legal tender which is not. However, you can exchange a gold-backed security or stock certificate or foreign currency for goods or services-- that is a perfectly legal transaction.

I wasn't aware that the people making Ron Paul-faced coins were representing them as legal tender. Is that your claim? It would have been pretty stupid, no? "Legal tender" means precisely that people can be forced to take a worthless piece of paper as payment, because the pols and their big gun say so. By the way, anything can be exchanged for anything else, so by your argument everything would be money. It's not. What you're talking about is barter. The fact that I might be able to trade my garden rake for a hammer doesn't make either of them money.

Doesn't whole or universal life insurance work much the same way (i.e., accumulating a cash value paid to every policyholder while also paying a disproportionate amount to those who die young paid out of the pooled premiums)?

Private firms invest in productive resources. Social Security does not.

That economy was sure unproductive in the 1950's, or the 1960's, or the 1980's, or the 1990's, or the last 8 years. It's horrible how we became the richest country on earth while having a Social Security program.

The US was a rich country before the 1930s. By the 1950s Western Europe had been devastated by war, and its economies mostly became more welfare-statish (or flatly socialist, as the United Kingdom) than ours. Who else do you want to campare to? Communist Russia? Being less diseased than your neighbors doesn't make you healthy.

Those unfunded liabilities can be easily met until 2070 or so with slight changes to the benefit formula.

I.e., cuts in benefits. That's a step in the right direction.

But as I recall, payout will exceed income to SS way sooner than 2070. Since the so-called "Trust Fund" is nothing more than a stack of IOUs from the government to the government, that's when the system goes into the red.

Now of course, it might still be possible to extricate ourselves from the mess in a relatively orderly fashion, although it becomes less feasible the longer we wait. Simply raise the age to collect benefits by 4 months per year, indefinitely. People nearing retirement need only work a little longer. Those farther out may wish to save a bit extra to tide themselves over. But young people entering the workforce will be advised that they are responsible for providing for their own futures, as is proper in a free society. And, with the SS tax being phased out, they'll have a better chance of doing so.
11.10.2008 5:04pm
guest:
Remove FDIC insurance and lets see what happens. End of story.
11.10.2008 5:27pm
Soronel Haetir (mail):
I wonder, in a free banking world, how successful a money warehouse/payment clearinghouse would actually be. IE, the features of a modern checking account backed by 100% reserves with a fee paid to maintain the account. How much would such an institution need to charge to be worthwhile?

Let any loans be made from time deposits, though I suppose you could still easily run into trouble if making 30 year loans from 3 or 6 month CDs.
11.10.2008 5:41pm
David Schwartz (mail):
So, I guess my challenge to Posner would be to distinguish FRB from a pyramid scam, and to Block to distinguish FRB from an insurance company. I'm not convinced either way yet.
With a Ponzi scheme, there is no reasonably plausible way it can all work out for the best. Barring the schemer winning the lottery and having a change of heart, someone must lose and lose big. Their loss must equal the total benefits, since losses are the only source of gains in a Ponzi scheme.

With FRB, the expected outcome is that everybody wins. It would take something exceptional for that not to happen. And everyone understands and accepts that risk.

For example, I want to buy a car. I don't have the $12,000 I have now, but I can pay for it over time. I borrow $12,000 at 7% from Joe. He gives me $12,000 that Moe deposited with him at 5%. As I pay back the $12,000, he uses that money to repay Moe, keeping the 2% difference.

Everybody wins. I get my car today. Joe makes 2%. Moe gets interest.

By properly aggregating and leveraging these transactions, the risk of an outcome other than the desired one can be made low. However, lowering risks has cost, and many people would prefer higher interest to lower risk.
11.10.2008 5:48pm
byomtov (mail):
Remove FDIC insurance and lets see what happens. End of story.

Why would you remove it?
11.10.2008 6:00pm
Dilan Esper (mail) (www):
It would have been pretty stupid, no? "Legal tender" means precisely that people can be forced to take a worthless piece of paper as payment, because the pols and their big gun say so.

And you are not required to do so. If you want to sell your car but will only accept 15 gold ingots in return, no law requires you to accept dollars instead.
11.10.2008 7:06pm
Dilan Esper (mail) (www):
Private firms invest in productive resources. Social Security does not.

You can't prove the worth of libertarianism by ASSUMING nothing the government does is efficient. E.g., those Social Security revenues that were used to pay for interstate highway construction in the 1950's and 1960's sure look to me like they were invested in productive resources.
11.10.2008 7:07pm
John W (mail):

Remove FDIC insurance and lets see what happens. End of story.


FDIC. Created in 1933 in Glass-Steangall act.

Fractional Reserve Banking. At least 2-400 years older.

Not to say a system of fractional reserve banking has problems without insurance to cover the risk of a run on the bank, but it's silly to say insurance is necessary to make it work.
11.10.2008 7:53pm
John S. (mail):

It would take us way off topic, and take more time than I can afford to spend, to tutor you about the sophistication of Einstein's concerns about the Copenhagen interpretation of quantum mechanics


Doc W,

No need to be condescending about it. I take it you are an expert, and I appreciate that. I was simply playing with the Schroedinger equation in Matlab today and the example was fresh in my mind. I won't claim to be an expert on the topic; but my view on Einstein's opinions (which I of course agree are very subtle) lend a bit of context to how you and I seem to think differently on FBR vs. the alternatives.

Einstein maintained, through the last published work I'm aware of, that his fundamental issue with quantum mechanics is that it rejects standards of realism; it doesn't provide a sense of reality satisfactory to him no matter how consistently true its predictions are.

However, the theory has held up against rigorous scientific examination for its ability to predict physical phenomena. I guess I fall into the instumentalist camp (being an engineer this makes sense to me - all I'm concerned with is if a model produce correct results, not the philosophy of why it works and if it meets my personal standards of how physics should look.)

In the same way, I see FRB as a functional system that, when given a reasonable set of controls, performs better than other historical systems even though it's imperfect and does not conform to the admirable ideals of minimal government.

The gold standard has been tried, and does not work well in any circumstance: I'll quote James Hamilton, who puts it more eloquently than I:

"A gold standard only works when everybody believes in the overall fiscal and monetary responsibility of the major world governments and the relative price of gold is fairly stable. And yet a lack of such faith was the precise reason the world returned to gold in the late 1920's and the reason many argue for a return to gold today. Saying you're on a gold standard does not suddenly make you credible. But it does set you up for some ferocious problems if people still doubt whether you've set your house in order..."

This historical and pragmatic perspective is what Dr. Block misses, imho - just as Einstein dismissed the pragmatic implications of quantum mechanics in favor of ideals. Dr. Block is arguing for a rational ideal, but encompassed in a system that historically does not solve the problems we currently face. Whereas more intelligent regulations, namely regulating all financial instruments as securities and restricting leverage ratios to rational levels just might.
11.10.2008 8:43pm
John S. (mail):
<blockquote>
And you are not required to do so. If you want to sell your car but will only accept 15 gold ingots in return, no law requires you to accept dollars instead.
</blockquote>

Excellent point here. It also raises a question on other works of Block. If gold is truly the preference of "freely choosing individuals", then why, since the start of the current financial crisis, has the price of gold dropped ($775/oz now, was $900 on 6/1/08, ~$1000 on 1/1/08) while there has been massive movement into T-Bills (0.12% last time I checked, down from 2% on 6/1/08 and 3% on 1/1/08)? Doesn't this indicate that T-Bills are the free market's "commodity" of choice rather than gold?
11.10.2008 9:46pm
subpatre (mail):
At the end of the day, the fact remains that the fractional reserve system has just cost $2 trillion of taxpayer money, in order to 'keep the system stable'.

That is a lot of instability.
11.10.2008 11:09pm
Dilan Esper (mail) (www):
subpatre:

That $2 trillion is a big number, but it's still far, far less than the economy produces in a year. And it's the first such bailout in decades and the largest one we've ever needed by far. In contrast, without fractional reserve banking, we'd lose the benefit of the money multiplier, which would mean a contraction that would last years and cost many more trillions.

Solving the current credit economic problems by eliminating fractional reserve banking is like treating dandruff by decapitation.
11.10.2008 11:21pm
Doc W (mail):
John S.--sorry about the snippiness on my part, and particularly my off-hand assumption that you don't know much about Einstein &QM. We deploy models to serve our purposes in many ways, including purely instrumentally to make predictions and build machines, but also to satisfy our curiosity and reach a sense of understanding the world. And that search for deeper understanding often pays off. Models that make accurate predictions for some purposes or in some range of parameters may be inaccurate, or inapplicable, or just not tell you all you could know in other situations. Think of classical thermodynamics, which works real well if you're willing to accept the 2nd law as a given, but haven't we gained lot by looking farther to find a basis in the spreading of energy over more quantum states or degrees of freedom?

Since you were working with the Schrodinger equation, do you know how disturbed Schrodinger was with the idea of quantum jumps, or collapse of the wavefunction when a measurement is made? To illustrate the problem he came up with the famous cat paradox, where it would seem, according to QM, that the cat is neither alive nor dead until observed, and then suddenly, somehow, it becomes one or the other. The dogma handed down from Niels Bohr and the Copenhagen school was that QM is a recipe for making predictions about the results of observations or experiments, period. But the problem is that the apparatus and the observer are made of atoms too, are quantum systems too, so there is no principled basis for applying Schrodinger evolution only to the observed system and not to the measuring device and observer. In recent years, a lot of progress has been made on ideas like decoherence and many-worlds, which if they don't give different predictions nevertheless provide useful insight to help folks working on things like quantum computing.

Anyway, as far as gold is concerned, my take is that a gold standard does work to constrain politicians' spending, or to make consequences for their irresponsibility, but rather than politicians' being held responsible, what happens is that the gold standard gets blamed instead for any problems. So then we get a monumental government-manipulated banking system with fiat money that contributes to periodic havoc in the market. It's just one more example of how government causes problems in the market that get blamed on the market and serve as excuses for more government intervention.

As far as being able to demand gold ingots in payment for your car, maybe you can do that as an individual in a private transaction, but no I don't believe you can go into business selling goods and services and refusing to accept dollars. This is where I'm no expert at all, but you know, it does say "legal tender for all debts public and private." As for government securities as a safe refuge, the thing is that the government has the biggest gun, which it will use to extract the money to pay what it needs to pay. Problem is, at some point the whole ship can go down, and we're all on it.
11.11.2008 11:12am
Doc W (mail):

those Social Security revenues that were used to pay for interstate highway construction in the 1950's and 1960's sure look to me like they were invested in productive resources.

Well, which is it--is SS a retirement insurance or is it just another tax that the feds spend on whatever they want? You might have a point if the feds built a system of TOLL roads and paid SS benefits from the tolls. But then we're up against the quaint notion that the government is a wise investor in productive capital. If that were true, then Communist Russia, Communist Eastern Europe, Communist China, and semi-socialized pre-Thatcher Britain would have been highly productive and wealthy, rather than the economic cesspools that they were.

As I've pointed out, the SS tax is just another source of income for the pols to spend as they want. As demographics change, they've upped the tax and now they've also begun to raise the retirement age, so that the SS tax continues to produce a surplus of revenue beyond what is needed to pay out benefits. And everybody supports this because by god we can't let SS become insolvent! What a neat political trick, rooted in the illusion that SS is insurance. Unfortunately, it can't continue indefinitely, but when the end comes the generations of corrupt pols who perpetrated the fraud will be safely retired and/or in their graves.
11.11.2008 11:34am
John S. (mail):
<blockquote>
In recent years, a lot of progress has been made on ideas like decoherence and many-worlds, which if they don't give different predictions nevertheless provide useful insight to help folks working on things like quantum computing.
</blockquote>

This is an excellent point.

<blockquote>
It's just one more example of how government causes problems in the market that get blamed on the market and serve as excuses for more government intervention.
</blockquote>

This is also a fair point, I should give some more thought to it's applicability with past gold standard experience.

Anyways, I do appreciate your insight into the QM stuff; though off topic here I find it perfectly fascinating.
11.11.2008 11:50am
Dilan Esper (mail) (www):
Well, which is it--is SS a retirement insurance or is it just another tax that the feds spend on whatever they want?

In reality, it is both. Although I think it should be 1 and not 2, at least in the sense that the social security taxes should be carried forward as an off-budget surplus until the boomers' retirements are paid for.

Still, what you guys are doing is letting your ideological preconceptions about government get in the way of reality. Government does lots of productive things, like build roads. And the US government is quite solvent and reliable, which is why (as someone noted above) people buy T-bills at a very low interest rate. So there's no reason to think, even if the government is irresponsible and spends the social security surplus, that it won't come up with the money to make good in the future. It always has in the past.

Libertarians don't trust the government. I get that. But the history of social security is actually a very powerful rebuke to that attitude. Maybe that's the real reason you guys hate it so much.
11.11.2008 1:15pm
Drex Davis (mail) (www):
calling fractional reserve lending fraudulent is incorrect.

calling it dangerous is correct.

a deposit is a short-term liability on a balance sheet, callable at any time by the depositor.

the bank lends (a portion of) the deposit and it becomes a long-term asset on the balance sheet.

any business worth its salt anywhere knows that the quickest way to insolvency is to fund a long-term asset with a short-term liability . . . yet this is what our banks do.

that's why any "callable liability" (i.e. deposit) is a bank-run-domino time bomb waiting to happen.

the problem, as i see it, is that most depositors do not understand what is happening with their deposits and the risks to those deposits. in that sense, they may feel "defrauded" once they understand what's going on.

block - wrong to call it fraud, right to call it stupid.
11.11.2008 1:20pm
Dilan Esper (mail) (www):
Anyway, as far as gold is concerned, my take is that a gold standard does work to constrain politicians' spending, or to make consequences for their irresponsibility, but rather than politicians' being held responsible, what happens is that the gold standard gets blamed instead for any problems.

That's a strange claim. The way humans, including politicians, will react to economic policy is part of the calculus as to whether the policy is a good policy. Indeed, isn't that what conservatives are always telling us about taxes? It isn't just the revenue you raise, but how economic actors will react to being taxed, which may harm the economy (and tax revenues) in the long term.

Or the drug war, a libertarian bogeyman, where the conduct of people to continue taking drugs becomes worse than the drug addiction problem that the policy was meant to solve.

Well, if politicians react to the gold standard by mucking with the exchange rate and doing work-arounds, how is that not a serious indictment of the policy?

(This actually gets at a broader point about budgets. The only way to cut spending is to cut spending. "Starving the beast" doesn't work. Balanced budget rules don't work. The only thing that works is actually doing the spending cuts, rather than trying to rely on some mechanism to do it for you. There always ends up being a work-around.)

As far as being able to demand gold ingots in payment for your car, maybe you can do that as an individual in a private transaction, but no I don't believe you can go into business selling goods and services and refusing to accept dollars. This is where I'm no expert at all, but you know, it does say "legal tender for all debts public and private."

That's not what that means at all. You are perfectly entitled to go into business and accept any form of payment you wish to. The only thing is, if you enforce one of your contracts in court, the court is going to award damages in dollars. Even that's not a big problem, however, because you can write your contracts so that the dollars will be the equivalent of the gold that you demanded in payment, so you can then go off and use it to buy gold.

The only thing stopping you from doing this is that THE FREE MARKET DOESN'T AGREE WITH YOU AND THINKS THAT TRADING IN GOLD INSTEAD OF DOLLARS IS IDIOTIC.
11.11.2008 1:21pm
Drex Davis (mail) (www):

You can't prove the worth of libertarianism by ASSUMING nothing the government does is efficient. E.g., those Social Security revenues that were used to pay for interstate highway construction in the 1950's and 1960's sure look to me like they were invested in productive resources.


an "investment" of social security, if it is truly an "investment", should net a return, and that return should *at least* to compensate for inflation-caused capital erosion.

social security withdrawals, today, are not coming from the social security pay-ins of yesteryear. they're coming from pay-ins today. it's unsustainable. we've got a tremendous amount of unfunded liabilities that are being paid not out of with-holdings, but off debt borrowing.

We can fund the liabilities through increased taxes today, or we can defer the tax until later by borrowing today and paying off the debt with tax later, or . . . we can let the liabilities go unfunded.

someone's going to get screwed . . . and it ain't the old people folks. it's us or . . .our children.

we can do what our parents' generation is doing and pass the buck to the next one, or we can "nad up" and bear the cost of the previous generation's profligacy.
11.11.2008 1:28pm
Drex Davis (mail) (www):

And this is why no one takes Lew Rockwell and the Von Mises Institute seriously.

Right. Except for those people who used Austrian theory and correctly called the tech bubble and housing bubble and kept their money, or made money shorting it.

There are a lot of very poor Keynsians walking around right now. The Austrian's are strategically buying up their forced liquidations.
11.11.2008 1:35pm
byomtov (mail):
drex davis,

I'd say "risky" is a better word than "dangerous." That may sound like picking nits, but I don't think so. Business is risky. That new product may not sell as well as you hoped. That doesn't mean it was stupid to do it.

And there are ways to guard against risks. Maintaining reserves, having adequate capital, avoiding too much of a duration mismatch, are all ways to do this.

Other methods include deposit insurance and the availability of liquidity from the Fed. These are part of government, of course, so some people automatically disapprove. I don't, and I doubt anyone whose ever gotten an FDIC payment when a bank failed does either.

The critical thing is that FRB has enormous economc benefits. So you can't just say, "It's risky, don't do it," without weighing the benefits.
11.11.2008 1:46pm
Drex Davis (mail) (www):
byomotov,
i think that the issue goes to the heart of what banking is or should be. is it depository protection? is it capital creation? is it both?

many depositors deposit in banks because they are trying to protect their capital, not generate a return on it.

banks are in the business of arbitraging rates based on deposits received and return opportunities.

this misunderstanding can lead to problems.

as far as the federal reserve bank's enormous benefits, if you think credit creation caused by non-saving is good and does not create malinvestment, then I suppose it's good, but I don't think the history of the federal reserve demonstrates this.

the artificial pegging of rates through the creation or removal of credit creates bad information for entrepreneurs and the people who actually allocate capital.

that's why you see see severe boom-bust behavior anywhere central bank fractional reserves are used to manipulate credit conditions (and, thereby, the economy . . . of course, in the name of "containing inflation").

in my study of central bank histories i see it as a great destroyer (not creator) or wealth. and in my LIVED EXPERIENCE i have felt its effects, as anyone who own a home has felt directly in the last 7 years or so . . .
11.11.2008 1:54pm
byomtov (mail):
Drex Davis,

many depositors deposit in banks because they are trying to protect their capital, not generate a return on it.

True. And deposit insurance as well as Fed lending help them do this. Not only that, but the bank's ability to lend out the money eliminates or reduces storage fees depositers would otherwise pay.

if you think credit creation caused by non-saving is good

I don't see what you're getting at here. The banking system, indeed the whole financial system, has as one of its purposes making savings available for investment. The intermediary - the bank - aggregates a lot of savings of different types and makes them avaiable to borrowers. Take away FRB and you lose a tremendous amount of investment flexibility. You have savings not being put to use - in effect being stuffed into safety deposit boxes. That's not good for economic growth, to put it mildly.


that's why you see see severe boom-bust behavior anywhere central bank fractional reserves are used to manipulate credit conditions

But there were large boom-bust cycles in the US well before the creation of the Federal Reserve. Panics were far from uncommon.
11.11.2008 3:02pm
Drex Davis (mail) (www):

I don't see what you're getting at here. The banking system, indeed the whole financial system, has as one of its purposes making savings available for investment.

Right. The problem is not when they make "savings" available for investment, it's when they make "non-savings" available for investment - credit from thin air created by central banks engaging in fractional reserve lending.

But there were large boom-bust cycles in the US well before the creation of the Federal Reserve. Panics were far from uncommon.


Yes. you will always have runs/panics happen when people en masse want to retrieve dollars they believe are liquid, but they're trapped in illiquid projects (duration mismatch). If you can't meet 100% demand requirements, you're always at risk; that's why fund lent out to illiquid assets *should* only be made from savings that have been made by people who understand it, agree to it, and stipulate what the duration of those terms can be. Otherwise, you are always at the threat of a run, whether you have a central bank or not.

It's arguable, but I'd argue that the FDIC creates moral hazard and leads consumers to hold banks less accountable and take less interest in their bank's practice rather than more.
11.11.2008 3:16pm
Drex Davis (mail) (www):
Is there a way to get rss feeds for comments on specific threads here, so that you know when someone has made a new comment on a post - I hate having to check back, I'd rather get rss notices?
11.11.2008 3:32pm
John W (mail):

Right. The problem is not when they make "savings" available for investment, it's when they make "non-savings" available for investment - credit from thin air created by central banks engaging in fractional reserve lending.


This just doesn't make sense. (and appears to go to a fundamental misunderstanding about how fractional reserve banking works-as some of the articles opponents put out say).

1) Central banks have nothing to do with fractional reserves, in principle. They regulate it today, but in principle, all you need is one bank. To "create" money, you need more than one bank-but again, there need not be a central bank.

2) So far as I can read, many opponents of fractional reserve banking think it goes like this:

Depositor goes to bank A, deposits $100.
Bank A then lets people borrow $900. (some say that the bank somehow "calls up the central bank" to get a truck full of money). This is usually analogized to a "malevolent goldsmith" who issues claim checks for twice the amount in their vault.

It just doesn't work like that. That would be fraud-but that's not fractional reserve banking.

Today, individual banks can't "create more money" than they have deposited. They just don't have it. Banks aren't giving people 'claim checks' which are then used as cash-they're giving borrowers the same money that is deposited.

How money is created in reality:

Bank A has deposits of 100, lends out 90.
Let's assume the bank got deposits in dollar bills, and lent out those same bills. Now there's 100 dollars in the economy-100 dollar bills, 90 in economy, 10 in bank.

The borrower has 90 dollar bills and owes the bank 90-his net worth is zero.

The bank has 10 real dollars and an obligation worth 90. It owes the depositor 100. Again, net worth zero.

The depositor has a credit worth 100. Net worth 100.

The whole economy has 100 dollars in it.
The borrower spends the money on toys. He now has 90 dollars in toys and a 90 dollar debt. Still net worth of zero.

But now we also have the shopowner. He has 90 dollar bills and no liability. He deposits them in bank B.

Now there are 190 dollars in the economy-100 held by the original depositor in bank A, 90 held by the toymaker in bank B, and a bunch of actors with zero net worth.

Note that NO BANK HAS EVER LENT OUT DOLLARS IT DOESN'T HAVE. There's no fraud, yet we've created money through fractional reserves. No central bank required.

In this example, banks can only lend dollar bills. But it's not hard to say they can lend money by (say) writing checks.

When I write a check, money is taken out of my account. Same applies for a bank that writes a check. Neither can write on without money to cash it-which makes sense intuitively-otherwise, where does the money come from to cash the check?

Banks solve this by clearing-at the end of the day, they total up all the checks they write, and instead of having to transfer big sums, they just have to transfer the net difference.

But either way, the point is that FRACTIONAL RESERVE DOES NOT MEAN THAT BANKS CAN GET 10 AND LEND 100. IT MEANS THEY CAN GET 100, LEND 90, AND KEEP 10-BUT THE 90 THEY LEND IS PART OF THE 100 DEPOSITED.
11.11.2008 3:40pm
Drex Davis (mail) (www):
You are correct. OK, there are two issues, some are conflated, and they're getting mixed up.

Fractional reserve lending merely means that you only keep a little bit of the deposits on hand for withdrawals. the rest you lend out. if the deposits are from savers, the risk here isn't credit expansion, it's capital loss to depositors, and also bank failure if there's a run b/c withdrawals cannot be made (and a host of other consequences.)

HOWEVER, with central bank fractional reserve lending to banks, the banks aren't lending out savings, they're lending out money that is, I'll try and show, created out of "thin air".

it's important to note that the fed puts money into banks (to be lent) by buying US gov't securities that the banks hold. these are us gov't debt securities that were created by the us treasury issuing debt.

here's what happened to create those notes. treasury issues a note, takes money in exchange, spends money. so no problem. gov't has debt, "someone" (bank) lent the money when it bought the security - the cash and note are just exchanging hands, no additional credit is in the system.

but look what happens next. when the fed "buys" these us gov't securities from banks, they are paying for it with money . . . where is this money coming from? it's not the money that the treasury previously borrowed. that borrowed money is being put to work in gov't spending.

no, the fed is using it's "check book" which is not backed by any saving (just the printing press).

so, again, note that no _savings_ were actually used to purchase the notes with from the banks.

now you have money available to be lent from both savers and money created out of thin air by the fed.

money supply up, interest rate down, more borrowing occurs, required return on projects is lower because the rate of the borrowed funds is lowered, more projects get investment, economy heats up (until rates rise).

does that make sense?
11.11.2008 3:55pm
Drex Davis (mail) (www):
John W. - a concise way of saying what the two issues/problems are is:

1. Fractional reserve lending by non-central-banks based on real savings runs the risk of capital loss and withdrawal risk. This doesn't have to be a considerable risk if depositors understand that their deposits are not 100% able to be withdrawn and lending is only made to very safe projects.

2. Fractional reserve lending by central-banks based on credit creation runs the risk of inflation, malinvestment, and booms/busts.

So both have risks. But most Austrians, as I understand it, are more concerned about Problem 2 because they beleive that Problem 2 makes Problem 1 above a much bigger problem (and a greater risk). In fact, Problem 2 makes Problem 1 much more likely to occur - greater risk of a run and capital losses much higher than otherwise would be.
11.11.2008 4:06pm
Drex Davis (mail) (www):
And, John, it's important to note that banks don't only lend people's deposits, they also lend funds they've borrowed from other banks (including the central bank), so this credit created from printed money finds its way into every single bank . . .

Loanable funds from real savings are mixed in with loanable funds from central bank thin-air-credit.

it actually punishes real savers b/c rates are lower than they would be . . . (so you get less real savers over time relative to central bank funds).
11.11.2008 4:10pm
Dilan Esper (mail) (www):
social security withdrawals, today, are not coming from the social security pay-ins of yesteryear. they're coming from pay-ins today. it's unsustainable. we've got a tremendous amount of unfunded liabilities that are being paid not out of with-holdings, but off debt borrowing

Repeating that a thousand times won't make it true. It is sustainable. It has sustained for 70 years. While there may need to be some relatively minor adjustments to benefits or taxes in the future, it can be solvent for at least 60 years more with those minor adjustments (beyond that point it's hard to estimate population growth, but there's no reason to think it won't continue to be solvent).
11.11.2008 4:23pm
John W (mail):
Drex,

It's good to debate this with someone who's both thoughtful and well-spoken. I'm glad to see that we agree that fractional-reserve banking, as it's performed by commercial banks, is unproblematic.

I don't disagree that the thing you describe happens. I plan, however, to show that that simply isn't fractional-reserve banking. It may be a problem, depending on how you feel about monetary policy. But it's just not fractional-reserve banking.

What you're describing is something called an "open-market operation." It's how monetary policy is actually carried out

As you note, a central bank/government treasury can create money "out of thin air." This may or may not be a good thing depending on its monetary policy goals.

But the treasury isn't acting as a bank. It really is, at least in theory, "just printing money"-it can act to expand or shrink the money supply. As a government, that is something it can do-which we may want if we want strong monetary policy. If we don't want it, it's a problem-but then, your problem is with the Secretary of the Treasury or the Chairman of the Fed.

But there is, quite simply, no "fractional reserve" involved. The central bank can just do this. It can do it regardless of how much money it has on hand, or how much gold there is in fort knox, or anything else.

That's the difference between an arm of the government and a commercial bank.

One example of this-as you note, the treasury isn't lending money when it issues bonds-it's borrowing money. When it uses that money to pay people, it's just spending the money it borrowed.

Neither of those is problematic.

The reason this affects fractional reserves is because when a central bank does this, it issues bonds-which, when deposited in a bank, can be counted as part of their assets and used as reserves. The dollar bills it borrowed, and then spent on (say) tanks, are also in the economy, and can also be used by banks as reserves if deposited.
(as a side note, the central bank can also borrow by issuing bonds that cannot be used as part of a bank's fractional reserves. That's a different type of operation).

Hence, there's more money in the economy. Similarly, when the central bank buys these securities, it's taking money out of the economy-as before, there are dollar bills and bonds, and afterwards, there are just dollar bills.

(in principle, this is a complicated way of "printing money"-the same effect would occur if the central bank just printed and spent dollar bills).

Under a fractional reserve system, that "new" money can then be multiplied. (the same would occur if, for example, exports were greater than imports-because the payment for them would similarly expand the national money supply).

But those are different things-again, a government can do this regardles of whether it has ANY assets to back them up. Government securities are backed by the good faith of the government. We may disagree about what that's worth-but I simply note that US treasury bonds are considered to be the safest investment there is, and the US government has never defaulted on a bond.

Further, a central bank knows whether or not fractional-reserve banking exists. It therefore knows whether issuing $100 of government securities will lead to $100 or $1000 of new "money" in the economy at the end of the day.

bottom line, one might reasonably agree or disagree with the proposition that monetary policy is done right, done wrong, or a terrible idea and ought to be gotten rid of.

But that has nothing to do with fractional-reserve banking.
11.11.2008 4:24pm
John W (mail):

And, John, it's important to note that banks don't only lend people's deposits, they also lend funds they've borrowed from other banks (including the central bank), so this credit created from printed money finds its way into every single bank . . .


But these are the same thing. Deposits are money the banks borrow from you or I. Borrowing are just the same thing on a larger scale. There's no real reason to be afraid of one and not the other..



1. Fractional reserve lending by non-central-banks based on real savings runs the risk of capital loss and withdrawal risk. This doesn't have to be a considerable risk if depositors understand that their deposits are not 100% able to be withdrawn and lending is only made to very safe projects.

2. Fractional reserve lending by central-banks based on credit creation runs the risk of inflation, malinvestment, and booms/busts.


Well, I disagree that 2) has anything to do with fractional-reserve lending, but it's right to separate the issues.

And 2) only makes 1) a greater problem if we're afraid that these things being issued by the central bank are going to become worthless. As noted, 1) means that each dollar of 2) has a much greater effect, but governments can take account of that.

Further, we have the same problem about dollar bills-that's really a problem with fiat money-money backed by nothing beyond the good faith of the government that issues it. That's true about the dollar bills in my wallet, and about the treasury bond a bank holds.
11.11.2008 4:30pm
Drex Davis (mail) (www):

Repeating that a thousand times won't make it true. It is sustainable. It has sustained for 70 years. While there may need to be some relatively minor adjustments to benefits or taxes in the future, it can be solvent for at least 60 years more with those minor adjustments (beyond that point it's hard to estimate population growth, but there's no reason to think it won't continue to be solvent).


You may be right, but at what cost?

Have you looked at how many payees have to pay into SS today in order to keep it solvent vs. how many have to today?

Do a google search on "social security is unsustainable" and you'll find a lot of data that shows that it isn't WITHOUT LARGE INCREASES IN TAXES ON FUTURE GENERATIONS, at least at current population rates and life expectancies.

anything is sustainable as long as you have enough slaves (involuntary servitude or burdened taxpayers) to keep it going . . .

here's one article that I pulled up.
http://www.ssa.gov/legislation/testimony_012604.htm
11.11.2008 4:35pm
Dilan Esper (mail) (www):
There are some minor errors in Drex's posts (like the fact that he confuses the FOMC's open market operations-- which are a way of regulating the money supply to control inflation and prevent recessions-- as if it is some sort of government plot to fund insolvent banks).

But the major problem is that his objections are all aesthetic. He doesn't like that the money multiplier effect results in additions to the money supply. He doesn't like that the federal reserve can use open market operations to inject money into the economy. He apparently doesn't like the idea of any money in a demand deposit being used to fund a long term loan. He doesn't like the idea that a bank might not have the reserves to pay off all the depositors at once.

The thing is, those are interesting, philosophical, aesthetic objections to our system. They are also completely unimportant.

In contrast, I am concerned with things that are important, like ensuring that people have an incentive to invest their money in order to spur a productive economy (achieved through a moderate inflation rate that punishes hoarding). I am concerned with ensuring that we have an independent decisionmaker which can prevent inflationary policies desired by politicians while also ensuring that we can inject money into the economy to prevent a recession. Indeed, such policies prevent the very bank runs that Drex is concerned about.

In other words, I want the economy to grow, people to work, people to spend and invest their money, and the business cycle to be controlled. Drex, on the other hand, is apparently more concerned with ensuring that anyone who has a dollar can keep a dollar without any worry that anything might ever happen to it, even if it means a flatlining or deflationary economy.

I just don't care that people don't like fiat money and would rather that their money be "worth something". I don't care that much that people face a tiny chance that if they all go to the bank at once, they may have to wait to get their money. That stuff is simply not as important as full employment, or economic growth, or having a rational, independent actor in charge of preventing inflation and smoothing out the business cycle. It's the difference between people who want to make sure the system works and people who just want to make sure that they have their's when the system fails and don't care that the policies they advocate make such a failure more likely.
11.11.2008 4:38pm
Dilan Esper (mail) (www):
Do a google search on "social security is unsustainable" and you'll find a lot of data that shows that it isn't WITHOUT LARGE INCREASES IN TAXES ON FUTURE GENERATIONS, at least at current population rates and life expectancies.

Those are the libertarians I referred to earlier, repeating it a thousand times in the hope of making it so.

We have actuaries who predict these things. The actuaries have been right in their solvency projections for decades. And their projections show no such dire situation (though they do call for some minor tinkering).

As I think I noted earlier, MEDICARE costs are going up quite a lot (as are health care costs generally), so if you want to get into the sustainability of that program, that's a different issue. But Social Security works just fine.
11.11.2008 4:41pm
Drex Davis (mail) (www):
John,
I want to read and digest what you've written. I read once and there were some areas that I just didn't understand. I have to do some work stuff, but I hope to read and respond.

Would it be fair to say that central banks have mechanisms wherein they create credit that is not backed by real savings?

Would it be fair then to say that this credit works its way through the banking systems which results in lending to other banks which is then lent out to borrowers fractionally?

Is it fair to say that credit created from savings and credit created from a government liability (promise) exist side by side in borrowed funds?

Is it fair to say that this, other things being equal, lowers the cost of funds to borrowers (interest rate being a function of the intersection of supply of credit, demand for credit)?

Would it then be fair to say that savers may get lower rates of return on savings when there's more US gov't credit in the system than they would if it wasn't?

Isn't it also true that higher rates of return attract capital, so that the US gov't discourages saving?

I know I'm not going directly to fractional reserve lending, but I think it's related. However, perhaps it's not as related as I may have imagined.

Are there no problems caused by having non-saving gov't credit injected into a fractional-reserve system in your opinion?

I think we can all agree that SOMETHING is causing the systemic problems we're seeing.

I guess, at bottom, is the real problem fiat currency and the fact that the federal government has mechanisms whereby it can use said currency to manipulate interest rates, leading to misallocation of resources?
11.11.2008 4:48pm
Drex Davis (mail) (www):
Dilan,
After completely misrepresenting my views and my motives, thank you, it's not aesthetics I'm concerned about.

I am concerned with the possibility (and now, reality) of systemic abuse of a banking system unchecked.

You seem content with the notion that government power will always be wielded by benevolent and competent individuals who have the capacity to manipulate a money supply in such a way as to insure perfect output.

HOW'S THAT WORKING OUT FOR YOU RIGHT NOW?

And, you think Hank Paulson is a fricking libertarian? Or David Walker, Comptroller General?

Please . . . it's a straw man.
11.11.2008 4:53pm
Drex Davis (mail) (www):
John, you said

I'm glad to see that we agree that fractional-reserve banking, as it's performed by commercial banks, is unproblematic.


I don't agree that it's unproblematic, only that the problems/risks CAN be managed. If that's what you mean by "unproblematic" then, OK.
11.11.2008 4:54pm
John W (mail):

I'm glad to see that we agree that fractional-reserve banking, as it's performed by commercial banks, is unproblematic.
I don't agree that it's unproblematic, only that the problems/risks CAN be managed. If that's what you mean by "unproblematic" then, OK.


I meant at least in that there is no fraud, no money coming out of nowhere-which seemed to be the issue. Like any other kind of transaction with risk, there can be problems, people can go broke, but it's not inherently bad. And on that, I think we agree.

Further, as I describe above, the transactions that lead to fractional reserves are not complicated, and are commonplace in and out of banks. In practice, you'd have to ban just about every kind of borrowing, lending, or credit transaction to remove any kind of thing that would amount to fractional-reserve banking.
11.11.2008 4:57pm
Drex Davis (mail) (www):

I just don't care that people don't like fiat money and would rather that their money be "worth something". I don't care that much that people face a tiny chance that if they all go to the bank at once, they may have to wait to get their money. That stuff is simply not as important as full employment, or economic growth, or having a rational, independent actor in charge of preventing inflation and smoothing out the business cycle. It's the difference between people who want to make sure the system works and people who just want to make sure that they have their's when the system fails and don't care that the policies they advocate make such a failure more likely.

Notwithstanding the incredibly understatements and callous dismissal of real issues in this passage as well as others you've written . . .

You seem to completely disassociate your ideal state from the systemic conditions that might bring it about.

Do you live in the real world, man?

I'm serious. Do you employ anyone? Do you support a family?

These are SERIOUS issues - the safety of capital, the return you can get on your savings, the rate of inflation.

I am the CEO of a 30 employee small business. I worked in investment banking for Goldman Sachs in NY before this. I deal with stuff in real life.

When the fed targets a rate it affects how we do business in the real world and I'm here to tell you that the law of unintended consequences is alive and well.

When the bank lowers rates it stimulates artificial demand in our markets and over-production, when it's raises rates, not only does it make some products money-losers (the return on the capital employed now lower than the cost of the funds), but it sucks credit out . . .makes it harder to get a loan, gets your line of credit lowered, makes it harder to roll over your line, leads to lower profits which leads to layoffs.

Man, this is the real world and this "perfection targeting" by the central bank is hurting, not helping, you you want to see happen in the economy.

It's not leading to full employment. It's not leading to sustainable capital allocation. It's distorting the signals entrepreneurs like me use in order to make decisions about the future.

When we see a low rate, it indicates that savings has gone up. Not only that but when credit's cheap the consumer buys more than he will when rates are higher (but you never know when or if that will be, so you make plans for next year based on purchase history today).

Please explain to me why booms and busts are necessary in your perfect keynsian system???
11.11.2008 5:08pm
John W (mail):
Drex,

Again, I'm glad to have this discussion, and if at the end of the day, we disagree, I think we're both better off for going through it-and I'd be happy to further discuss anything you're confused on.

I think I'm myself confused by your distinction between "saving" and "non-saving" credit. As far as I can understand, you're using saving to describe deposits by individuals (although there's no difference between that and deposits by large corporations), and the second to describe money "printed" by the government.


Would it be fair to say that central banks have mechanisms wherein they create credit that is not backed by real savings?


Yes. Central banks have mechanisms where they can create credit not backed by anything. We can examine those through looking at the real-world ways they do so, but for the purposes of simplification, I'm happy to treat them as simply printing money and spending it.


Would it be fair then to say that this credit works its way through the banking systems which results in lending to other banks which is then lent out to borrowers fractionally?


Yes, insofar as that goes. It works its way through the banking system pretty simply: the central bank buys something from someone. That someone then has dollar bills, and deposits them in their bank. Those bills are then lent out by that bank, and so on and around. Whether it buys things from a great big corporation or you or I, the same process takes place.
(if you want to see how it works when a bank buys a bond from the government, that changes nothing. Before that transaction, the bank has dollar bills, perfectly good as reserves. It then buys a government bond, and so has one bond instead of dollar bills. The bond is still good as a fractional reserve, but that bank has nothing change-it has $1000 in assets before buying bonds, and $1000 in assets afterwards. But now the government has dollar bills that it can buy things with)

Further, (at least in a regulated system), the government can determine what is and is not a valid form of reserve (for example, an alpaca farm isn't)-so if the treasury issues two kinds of bond, A and B, (where A can be counted as bank reserves and B cannot), the government can control if its borrowing increases the monetary supply-by just choosing which kind of bond to sell.


Is it fair to say that credit created from savings and credit created from a government liability (promise) exist side by side in borrowed funds?


Again, sure, so far as it goes--there's really no difference. When I save money, I'm getting paid in dollar bills. Those are credit created from a government promise. As noted above, we can treat how a government creates money as just printing dollar bills. So in effect, all the credit created is based on government promises.


Is it fair to say that this, other things being equal, lowers the cost of funds to borrowers (interest rate being a function of the intersection of supply of credit, demand for credit)?


Well, I'm not an economist. So take this with a grain of salt-I have little confidence (given the time I've spent thinking about it) about my analysis of which way causes which.
But I do agree that monetary policy is designed to control interest rates. Used one way, surely it will lower them-just as, I hope you agree, that the government can also act to raise interest rates.

Also remember that the interest rate is the price of borrowing-so if the government wants to borrow more than there is demand for, it will have to raise the rate it offers to borrowers.


Would it then be fair to say that savers may get lower rates of return on savings when there's more US gov't credit in the system than they would if it wasn't?

It would be fair to say the government can act to give savers higher, or lower rates of return on their savings. However, most bank accounts either give no interest at all, or give a fixed rate much lower than that offered on treasury bonds. CDs and so on are the instruments most affected by changing interest rates.


Isn't it also true that higher rates of return attract capital, so that the US gov't discourages saving?

Sometimes that's a good thing. Sometimes we want people to spend money-as that money goes to someone else, and gets spent, and so on and so forth. If everyone "saved" all their money by putting it in their wallet, the economy would collapse-as nothing would be bought or sold.



Are there no problems caused by having non-saving gov't credit injected into a fractional-reserve system in your opinion?

Sure-there can be problems with ANY injection of money into a banking system-be it by the government, or by the balance of trade. Those problems can be made worse, or the benefits made much stronger in a fractional reserve system where any injection is multiplied. I should note that, however, if the government can print money, then it can cause the same damage no matter if the system is or isn't fractional-reserve; the only difference would be how much money it'd have to print to reach the same result.

Intervention can also be very helpful if, as today, the problem is that credit markets aren't working, and hence the "cost" of borrowing money is too high-other parts of the economy would do better if the interest rate was lowered.

I don't see that "non-saving government credit" is any more or less dangerous than any other kind of money. I also note that, at least at base, all fiat money is "non saving government credit" when issued-every dollar bill in your wallet is a government-issued negotiable instrument that, when printed, wasn't backed by any asset of the government.


I guess, at bottom, is the real problem fiat currency and the fact that the federal government has mechanisms whereby it can use said currency to manipulate interest rates, leading to misallocation of resources?


Well, I don't find anything wrong with fiat money. It's one of those things that, were it not to exist, someone would probably invent it. I'd rather that be a government that has existed for some 240 years, and has never defaulted on a bond, rather than a bank to which those things don't apply.

I think there are real problems with commodity-based currency, one of which is that it's then effectively impossible to actually manage the economy through monetary policy.

I think government intervention can lead to misallocation, or can repair misallocation of resources. It depends on the circumstances. I think the current credit crisis is perhaps an example of a problem caused by the market misvaluing assets and hence misallocating resources. Is the solution intervention or lack thereof? Beats me-I'd need about eight more years of study and twenty more of experience to have a real opinion on that.
11.11.2008 5:27pm
Doc W (mail):

Anyway, as far as gold is concerned, my take is that a gold standard does work to constrain politicians' spending, or to make consequences for their irresponsibility, but rather than politicians' being held responsible, what happens is that the gold standard gets blamed instead for any problems.

That's a strange claim. The way humans, including politicians, will react to economic policy is part of the calculus as to whether the policy is a good policy. Indeed, isn't that what conservatives are always telling us about taxes? It isn't just the revenue you raise, but how economic actors will react to being taxed, which may harm the economy (and tax revenues) in the long term.

The pols take us off a gold standard in order to evade the immediate negative effects of spending irresponsibly, and people get bamboozled into thinking that the gold standard was to blame for negative effects of the pols' irresponsibility, and your point is what?? That going off the gold standard as a positive effect on pols' responsibility?

Well, which is it--is SS a retirement insurance or is it just another tax that the feds spend on whatever they want?

In reality, it is both.

No, the whole point is that it can't be both. If the SS tax is just another tax that the pols spend any which way, then SS benefits are just a non-means-tested welfare program for old folks.

You are perfectly entitled to go into business and accept any form of payment you wish to...

The only thing stopping you from doing this is that THE FREE MARKET DOESN'T AGREE WITH YOU AND THINKS THAT TRADING IN GOLD INSTEAD OF DOLLARS IS IDIOTIC.

Ok, I guess this must be what it's like to argue with a 3-year-old. "Legal tender" means you have to accept it in payment. The market is NOT free. What part of that don't you understand?

[re SS] It is sustainable.

Repeating that a thousand times won't make it so. For a number of years SS had a large ratio of payers to payees, along with modest benefits that weren't supposed to be a complete substitute for individual savings. Along the way, pols found it expedient to raise benefits (and thus expectations), even while the demographics were changing to an older population. The system is broke the moment payout exceeds pay-in, precisely because there is no actual "Trust Fund," no reservoir of commodities and productive capital generating wealth to which the hopeful beneficiaries have a valid claim. All there is is the willingness of future pols to continue to extract sufficient funds from future generations. If THAT is sustainable, it's the only sense in which SS is. But that's not insurance, it's merely coercion.
11.11.2008 5:58pm
John W (mail):

Ok, I guess this must be what it's like to argue with a 3-year-old. "Legal tender" means you have to accept it in payment. The market is NOT free. What part of that don't you understand?


Not true. Legal tender means it is considered to be "a valid and legal offer of payment for debts when tendered to a creditor."

1) if you're not a creditor, you don't have to accept legal tender. It's that simple. Most people buying things aren't creditors-they pay cash for goods, and there's no credit involved.

If you'd rather agree to buy things and pay in bananas, that's your prerogative. I may not deal with you, and that's mine.

2) It doesn't mean you have to accept the "valid and legal offer of payment." If you don't, a court will conclude that you've given up the debt--i.e. that payment has been tendered and refused. But that's only when someone owes you money, and you're trying to get them to pay you--making an offer in legal tender lets them argue that "I tried to pay, and he refused it."


www.ustreas.gov says:

The pertinent portion of law that applies to your question is the Coinage Act of 1965, specifically Section 31 U.S.C. 5103, entitled "Legal tender," which states: "United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues."

This statute means that all United States money as identified above are a valid and legal offer of payment for debts when tendered to a creditor. There is, however, no Federal statute mandating that a private business, a person or an organization must accept currency or coins as for payment for goods and/or services. Private businesses are free to develop their own policies on whether or not to accept cash unless there is a State law which says otherwise. For example, a bus line may prohibit payment of fares in pennies or dollar bills. In addition, movie theaters, convenience stores and gas stations may refuse to accept large denomination currency (usually notes above $20) as a matter of policy.

11.11.2008 6:10pm
Doc W (mail):
By the way, over at Liberty &Power, Wendy McElroy posted a link to an article about Congressional hearings giving the soapbox to some group that wants to confiscate private retirement funds and place them under the control of the SS Administration, in order to "protect" us from the vagaries of the market. This is too serious to chuckle about the obvious irony of the feds mucking around in financial markets and causing a crash, then proposing to protect us from their own depredations.

link
11.11.2008 6:10pm
byomtov (mail):
"Legal tender" means you have to accept it in payment. The market is NOT free. What part of that don't you understand?

No. It means you have to accept it in payment of debts. You don't have to accept it in payment for goods or services. The local dry cleaner can decide to accept only pieces of eight in payment. He won't stay in business long, but that's his problem.

The US Treasury explains:

There is, however, no Federal statute mandating that a private business, a person or an organization must accept currency or coins as for payment for goods and/or services. Private businesses are free to develop their own policies on whether or not to accept cash unless there is a State law which says otherwise. For example, a bus line may prohibit payment of fares in pennies or dollar bills. In addition, movie theaters, convenience stores and gas stations may refuse to accept large denomination currency (usually notes above $20) as a matter of policy.
11.11.2008 6:23pm
byomtov (mail):
OK. Should have left it to John W., who's doing a fine job.
11.11.2008 6:25pm
Drex Davis (mail) (www):

By the way, over at Liberty &Power, Wendy McElroy posted a link to an article about Congressional hearings giving the soapbox to some group that wants to confiscate private retirement funds and place them under the control of the SS Administration, in order to "protect" us from the vagaries of the market. This is too serious to chuckle about the obvious irony of the feds mucking around in financial markets and causing a crash, then proposing to protect us from their own depredations.

This just happened to my friends in Argentina ... (confiscation of their private pensions by the gov't)

as you say, it really is no laughing matter.
11.11.2008 6:31pm
Doc W (mail):

But that's only when someone owes you money, and you're trying to get them to pay you--making an offer in legal tender lets them argue that "I tried to pay, and he refused it."

Right--so whenever someone owes you money, you have to accept the legal tender. I appreciate the distinction you're making and thank you for the correction, but it still seems that any kind of serious business is going to get forced into accepting the greenbacks, and so that form of money has a built-in advantage stemming from force, not market choice. The other way that force comes in, as I mentioned much earlier, is exemplified by the trouble those people got into for minting coins with Ron Paul's visage.

The way this thread got into legal tender is when I suggested that private competing currencies would probably be backed by commodities, and somebody said we actually do in effect have competing currencies but people prefer dollars. Legal tender laws are part of the reason why that claim is vacuous.

I'm outa here. Thanks all. I will check back tomorrow just to look. Doubtless some other thread will get into this stuff one way or the other.
11.11.2008 6:37pm
John W (mail):

Right--so whenever someone owes you money, you have to accept the legal tender. I appreciate the distinction you're making and thank you for the correction, but it still seems that any kind of serious business is going to get forced into accepting the greenbacks, and so that form of money has a built-in advantage stemming from force, not market choice. The other way that force comes in, as I mentioned much earlier, is exemplified by the trouble those people got into for minting coins with Ron Paul's visage.


But... in that case, the force that makes the business accept greenbacks would be MARKET FORCE. You're saying "any serious business would have to accept dollars, or else it'd go broke because nobody would do business with it." That's the market saying that there's demand to buy things and pay dollars, and no demand for things that must be bought in Ron Paul dollars.

Further, if people don't want to buy things for gold, or ron paul dollars, or bananas, then as much as you might want to make them do so, it's the most antilibertarian rule imaginable to compel them to do so. If people don't want to do business with someone mandating payment in gold, and he goes broke, that's a pure example of the market working.
11.11.2008 6:45pm
John W (mail):
Or to put it another way, if market choice favored using bananas as money, how would we find out? We'd try to sell things for bananas, and we'd do well. If market choice favored gold, people would buy things in gold. There's no reason stopping them except for the fact that people want to use dollars as money, and don't want to use gold as money.
11.11.2008 6:47pm
byomtov (mail):
Wendy McElroy posted a link to an article about Congressional hearings giving the soapbox to some group that wants to confiscate private retirement funds and place them under the control of the SS Administration, in order to "protect" us from the vagaries of the market. This is too serious to chuckle about the obvious irony of the feds mucking around in financial markets and causing a crash, then proposing to protect us from their own depredations.

Get back to us when this is a serious proposal, say around the year 2359.
11.11.2008 8:15pm
John S. (mail):
<i>If market choice favored gold, people would buy things in gold. There's no reason stopping them except for the fact that people want to use dollars as money, and don't want to use gold as money.</i>

One small technical point on this. President Ford's repeal of the prohibition on owning gold did not release the prohibition of using gold as currency. Quoted from wikipedia:

<i>The Gold Clause Resolution of 1933, which makes unlawful any contracts which specify payment in a fixed amount of money or a fixed amount of gold. That is, contracts are unenforceable if they use gold monetarily rather than as a commodity of trade.</i>

Gold can be traded as a commodity for commodities, goods or services, but not used as money. However, if you look at the difference in performance between T-Bills and Gold price, you get a direct indication of the free market preference for gold vs. T-Bills. T-Bills have become the strong preference in times of turmoil; right now they are returning only 0.12%.

The market prefers government intervention. To me, this should cause a logical liberatarian connundrum: Does a dogmatic liberatarian agree that the free market should be honored even when it contradicts core liberatarian values, i.e. preferring government intervention? Of course, I've never had a good handle on how Libs think, so this supposition could be completely off base.
11.11.2008 9:36pm
John W (mail):

One small technical point on this. President Ford's repeal of the prohibition on owning gold did not release the prohibition of using gold as currency. Quoted from wikipedia:

The Gold Clause Resolution of 1933, which makes unlawful any contracts which specify payment in a fixed amount of money or a fixed amount of gold. That is, contracts are unenforceable if they use gold monetarily rather than as a commodity of trade.

Well, that only seems to ban a contract that is payable in gold or currency-it doesn't seem to read to ban contracts that exchange goods or services for a fixed sum of gold. Furthermore, the wiki cite doesn't seem to refer to a current statute. All I can find offhand in the U.S.C. is as follows:


31 USC 5118:
(1) "gold clause" means a provision in or related to an obligation alleging to give the obligee a right to require payment in—
(A) gold;
(B) a particular United States coin or currency; or
(C) United States money measured in gold or a particular United States coin or currency.



But that has the proviso that:


(d) (1) In this subsection, "obligation" means any obligation (except United States currency) payable in United States money.
(2) An obligation issued containing a gold clause or governed by a gold clause is discharged on payment (dollar for dollar) in United States coin or currency that is legal tender at the time of payment. This paragraph does not apply to an obligation issued after October 27, 1977.


Section (D) seems, to be the portion banning gold clauses in private obligations-or more precisely, to eliminate the effect of gold clauses by allowing them to be satisfied by payment in U.S. coin. However, by its own text, that prohibition does not apply to obligations created after OCt 27, 1977.

I'm not myself a lawyer, and can't give advice on what that means in a legal sense. But to me, the text seems not to ban a contract for payment only in gold, and either way, doesn't seem to apply to any contract after 1978. I'm sure some lawyer will come along and clarify anything I got wrong.

11.11.2008 10:14pm
John W (mail):

The market prefers government intervention. To me, this should cause a logical liberatarian connundrum: Does a dogmatic liberatarian agree that the free market should be honored even when it contradicts core liberatarian values, i.e. preferring government intervention?

I also lack insight into the libertarian mindset-but I'm not sure I see the government intervening to the extent it is selling securities people want.

Of course, the government is intervening in the market in a number of ways-but I'm not even sure a libertarian would have a problem to the extent the government is participating in the bond market by borrowing money by issuing treasuries. And if it is selling a financial product that is safer/gives a better return, would a libertarian really go so far as to reject it just because it happens to be government-issued?
11.11.2008 10:24pm
Dilan Esper (mail) (www):
I am concerned with the possibility (and now, reality) of systemic abuse of a banking system unchecked. You seem content with the notion that government power will always be wielded by benevolent and competent individuals who have the capacity to manipulate a money supply in such a way as to insure perfect output. HOW'S THAT WORKING OUT FOR YOU RIGHT NOW?

There is nothing about our current problems that can't be made much, much worse by eliminating fractional reserve banking. Further, one of the keys to solving our current problems is to have an independent central bank with a lot of power.

I don't think your argument is any more persuasive than "see, something went wrong, that proves we should tear down the whole system and do what I've wanted to do all along".
11.12.2008 12:38am
Dilan Esper (mail) (www):
These are SERIOUS issues - the safety of capital, the return you can get on your savings, the rate of inflation.

Not really. Mild inflation is very good for your business, because without it, people would hoard their money and there would be no investment capital. And "safety" isn't the only important aspect of a financial system. As long as risk is manageable, it is priced into the cost of capital. And you need risk to get reward. Finally, a higher return on savings requires higher interest rates, which leads to contraction of the economy, which means less customers, which again would be terrible for your business.

Bottom line, if all you care about is stopping inflation and ensuring that nobody who saves a dollar loses any value over time, you get a stagnant economy with no growth and no increase in the standard of living, plus 18th Century style panics every few decades. So no, I think that stuff is more important than whether your dollar is worth 97 cents next year.
11.12.2008 12:42am
Dilan Esper (mail) (www):
Ok, I guess this must be what it's like to argue with a 3-year-old. "Legal tender" means you have to accept it in payment.

Actually, you are arguing with a lawyer who tries contract cases. I could draft you an enforceable contract for payment in gold. And if the person didn't give you gold, you would have the right to refuse performance and sue for breach.

The ONLY thing "legal tender" means is that when you get the judgment, it will be for the dollar value of the gold required for performance.

You might want to learn a bit about the law before throwing around concepts like "legal tender" that you saw misdescribed on Lew Rockwell's websites.
11.12.2008 12:45am
Dilan Esper (mail) (www):
Right--so whenever someone owes you money, you have to accept the legal tender. I appreciate the distinction you're making and thank you for the correction, but it still seems that any kind of serious business is going to get forced into accepting the greenbacks, and so that form of money has a built-in advantage stemming from force, not market choice.

Nope-- the only people you have to accept greenbacks from are the courts and the government. Everyone else, you can require payment in gold.

Again you guys are skirting the issue. You would think if there was so much pent up demand for a currency that was "worth something", that people could make a ton of money trading goods and services for gold or gold-backed securities. But you can't, and it isn't because the federal government is stopping you.
11.12.2008 12:48am
Dilan Esper (mail) (www):
And John W's interpretation of Section 5118 is correct. There is caselaw upholding contracts payable in gold as enforceable.
11.12.2008 12:50am
Doc W (mail):
Here's the link to an article on what happened to the folks minting Ron Paul coins.

link

The idea that we have a free market of competing currencies is absurd.

the only people you have to accept greenbacks from are the courts and the government. Everyone else, you can require payment in gold.

Right. So if someone owes me gold and doesn't pay gold, I can't make them pay gold. I can take the to court and get dollars. And the fact that you can draw up a contract requiring gold doesn't make gold money.

As a kid, I remember that dollars were actually commodity backed. It said "Silver Certificate." Dimes, quarters, and half-dollars were silver. I believe I even remember silver dollars circulating as ordinary dollars. Now we just have fiat currency. Will people continue to accept it? Sure, until the day they don't. By God, let's hope the pols don't ever screw up quite so badly as to make that happen.

Wendy McElroy posted a link to an article about Congressional hearings giving the soapbox to some group that wants to confiscate private retirement funds and place them under the control of the SS Administration, in order to "protect" us from the vagaries of the market. This is too serious to chuckle about the obvious irony of the feds mucking around in financial markets and causing a crash, then proposing to protect us from their own depredations.

Get back to us when this is a serious proposal, say around the year 2359.

Well, it's actually happening now in Argentina. If it doesn't happen here, it will be because people stood up and said no before it was sprung on them. That means they have to be informed. And that means they have to uncover their ears long enough to listen.
11.12.2008 5:44pm
Dilan Esper (mail) (www):
1. The Ron Paul liberty dollars people were purporting to produce counterfeit coinage. That's what they are getting in trouble for. Bank notes, securities, scrip, coupons, and other forms of non-FRN "money" are fine as long as they don't purport to be legal tender.

2. If you contract in gold, and someone refuses to pay you gold and pays you dollars, you can refuse tender and they are in breach. You can sue them. Yes, the recovery will be in dollars (assuming the Court doesn't give you specific performance), but it will be the dollar value of the gold that you were supposed to be paid so you can simply buy gold with the dollars.

As a kid, I remember that dollars were actually commodity backed. It said "Silver Certificate." Dimes, quarters, and half-dollars were silver. I believe I even remember silver dollars circulating as ordinary dollars. Now we just have fiat currency. Will people continue to accept it? Sure, until the day they don't.

This is the real issue, and it is totally aesthetic. Some libertarian paranoids living in bomb shelters with arsenals and foodstocks are worried that the currency won't be worth anything unless it is "backed" by something. And the question is, is it worth it to ruin the economy and to give up the ability to do countercyclical monetary policy in order to assuage the fears of a bunch of loons. It isn't.
11.13.2008 2:21pm
leogex (mail):
A demand deposit can't be a loan. Ownership of it hasn't been given up in lieu of a future return. One could open 10 accounts in the same bank for $100,000 each,wand demand all his money back in the next minute. Since it's a demand deposit the bank would have to comply.

A demand deposit as a loan would seem to require an open end on the date of pay-off is such a thing even legal or smart?
11.13.2008 7:05pm
Dilan Esper (mail) (www):
A demand deposit can't be a loan. Ownership of it hasn't been given up in lieu of a future return. One could open 10 accounts in the same bank for $100,000 each,wand demand all his money back in the next minute. Since it's a demand deposit the bank would have to comply. A demand deposit as a loan would seem to require an open end on the date of pay-off is such a thing even legal or smart?

It's obviously smart; banks make tons of money on them.

As for legal, sure. Bank regulations permit them. Further, it is a loan. You just have to think about a loan that can be called at any time. You'd never personally want such a term, because it would make it difficult to invest the money you were loaned. But a bank, with deposits from thousands of customers, can make it work, because the chances that they will all call it in at once are so small, so you only need to keep a fraction of the reserves on hand.
11.14.2008 11:41am
Sammy Finkelman (mail):
Fractional reserve banking is a system in which you can give away your money and have it too.
11.16.2008 8:55pm
Peter Halferding (mail):
David Walser attempts to make an argument about insurance. This argument is nonsense. Your typical retail insurance company does indeed the math, Life insurance in normal times does receive more polis payments. However to cover extreme disasters they also re-insure and ultimately insurance ends up with the Names in Lloyds of London. These so-called Names, guarantee payout with all their assets for a rather high-premium.

Off-course names can go broke too. That is solved by proper vetting of the Names and create steep entry tresholds in possessions before they are allowed to enter that market.

So in case of insurance, there is ultimately a real, non-fractional asset base (instead, it is the reverse of fractional, a Name cannot limit its payout when called in, he puts his entire fortune at risk for honouring extreme circumstances claims for a very high premium).
11.29.2008 7:21pm
terrymac (mail):
Libertarians generally argue for a free market in banking; some argue that FRB would violate the conditions for a free market, but that's a debatable point. What is not debatable is that the Federal Reserve System has failed to deliver on its stated goals: monetary stability, maintenance of employment, and stability of the banking system.

Regarding inflation: my parents were able to see a movie in the 1930s for a nickel. The cost today is $7 or more. Numerous other examples show that prices have risen enormously since 1913. Far from stabilizing the money supply, the FRB has generated huge amounts of inflation. Lately, they have actually announced a policy of encouraging a steady amount of inflation, as if this were a positive good.

Regarding unemployment: we are currently seeing high unemployment; many of us recall a similar period in the 70s; and the Great Depression surely was not an era of high employment.

The Federal Reserve System is not delivering the goods. We should look into better alternatives. When people point out that the emperor is in his birthday suit, dismissing them as "crazy" does not change the underlying reality of the situation.

A stable, honest money system would promote investment, increased productivity, a rising standard of living, and retirement security. What's not to like? Only one thing: honest money would force the government to be honest. It would curb those wild inflationary spending sprees.
5.19.2009 10:47am

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