Amagi Podcast @ Think Liberty – Episode01 – Original Sins Of Libertarian Thought

MMT

In our first episode of the new weekly Amagi podcast on the Think Liberty network, Dylan and Nima discuss common libertarian myths and misconceptions about the economic system.

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100% Reserve vs. Fractional Reserve Banking

First off, this post assumes that the reader knows how money originated. If this is not the case, then please read the first three paragraphs about the History of Money.

Fractional Reserve Banking:

  • When person A deposits $1000 cash money in a bank account the bank credits his checking account with $1000 (a claim to $1000 in cash) and now has $1000 cash in its vault.
  • It now lends $900 (90% of $1000) to person B in a credit transaction, by crediting his checking account with that amount, meaning he now has a claim to $900 in cash.
  • B will exchange those $900 against goods obtained from C by writing a check over $900, drawn upon his checking account.
  • Now C’s bank employee calls up someone at A’s bank and requests $900 in cash, so $900 in cash are transferred from A’s bank to C’s bank.
  • Now A’s bank has a) vault cash of $100 b) a claim to $900 from B in repayment of the loan , and c) its customer A has a claim to $1000 cash on his checking account. He exchanges this claim against goods as if it were as good as money, and people accept it as if it were money. For all intends and purposes, and  by definition, it thus is actual money.
  • This, multiplied, leads to a situation where all banks hold only 10% of what customers deposited in actual cash in their checking accounts.
  • But as all actions do, this procedure has consequences. The amount of money in circulation increases. A and B act as if they have $1000, and $900 respectively, prices for goods obtained increase, inflation ensues, and speculation increases as a corollary occurrence. Those who obtained the newly created credit money first (mostly investors and speculators) get to buy up goods at lower prices, those who receive the money later (mostly wage earners) lose out as prices have already increased.
  • The correction of these inevitable misallocations only appears at a later point in time. All the well known and undesirable effects of credit expansion and the business cycle ensue
  • At the center of this system is the central bank, which creates new fiat money in the form of banknotes and uses it to buy up assets from different regional central banks which in turn obtain those assets from commercial banks across the country which in turn obtain them from individuals and businesses by making loans, such as the loan made to B by A’s bank as outlined above.
  • Without such a central bank and without the concept of fiat money which provides a backstop for potential liquidity issues, this system, and with it the primary cause of never ending booms, busts, and excessive speculation, would collapse immediately.

100% Reserve Banking:

  • Under 100% reserve banking, a bank would keep 100% of the money deposited into a checking account in its vaults.
  • If it wanted to obtain money to make loans, it would have no other means than to obtain fixed time deposits, paying the depositor interest over time, and only releasing it back to the depositor after the agreed time has passed.
  • This system keeps all the different individuals’ expectations and actions in balance. No inflation would ensue. No additional money could be created by the banks.
  • 100% reserve banking would be the industry standard in banking if no central bank and government intervention in the banking business existed, and if people were left the choice to decide for themselves which money they prefer to use. As the History of Money has shown us, the people voluntarily chose the metals gold and silver for this purpose.
  • Each bank would be fully responsible and liable for its own dealings, no nationwide banking cartel would exist, no central bank could provide a backstop for liquidity shortages.
  • If a bank were to attempt the fraudulent scheme of fractional reserve banking, it would immediately be drained of its money reserves and swiftly be put out of business. In addition to the lack of a liquidity backstop, the lack of a fiat money would allow different banks to independently issue their own branded claims to money deposited. The value of such claims would drop quickly if their issuance were out of step with the money deposited.
  • Only prudent banks could prevail under such system in the long run, and their number one motivation would be to remain prudent so as to maximize their customer base and by extension their profit.

I recently had a discussion on reddit.com with a user regarding the merits of 100% reserve banking. It was in regards to an article on mises.org, called Gold versus Fractional Reserves. He understood the pernicious effects of fractional reserve banking but ironically did not understand how 100% reserve banking would solve its shortcomings. Below please find this discussion which I believe is very relevant to pinpoint some of the major misunderstandings about money, credit, and banking (his statements are in blockquotes):

No one has been able to explain to me what they mean by “100% reserve banking”. By definition, if money is loaned out, you don’t have 100% reserves. You can only have 100% reserves by not making loans.

It’s hard to see how that can be called “banking”.

Some try to make a distinction between demand deposits and timed deposits but that can’t possibly make a fundamental difference, and I’ll provide an airtight proof of that:

With modern technology, I can take any demand account and convert it with no loss of generality, nor any functional difference to the depositor, into a 1 hour (or 1 second) revolving timed deposit account. Tell me again how this causes a magical transformation?

A gold standard is completely orthogonal to fractional reserves.

A short answer to your question

“No one has been able to explain to me what they mean by “100% reserve banking”. By definition, if money is loaned out, you don’t have 100% reserves. You can only have 100% reserves by not making loans.”

  • This is true for Demand Deposits (Checking Accounts). Money in checking accounts should not be loaned out because the depositor treats it as money withdrawable anytime. If they do loan it out it creates an inflationary credit expansion, speculation in assets, and price increases of certain goods.

A timed deposit account such as a CD is one where the deopsitor commits to a specific period for which he will not withdraw his money, so the bank can go ahead and loan it out for THAT specific period.

A 1 hr or 1 second demand deposit account doesn’t make much sense because the borrower would have to pay back the money within 1 hr or 1 second. But this is not what happens under our current banking system by the way. 80% of demand deposits are loaned out in long term loans. Plus it still violates the property rights of the depositor. He has to specifically agree to the terms of how much money is loaned out.

Otherwise we will get into a mess commonly referred to as a “financial crisis”, because there is never enough money in the system to pay off all loans.

I’ve had this discussion at length before. All that timed deposits change is the speed at which this all happens, and that only because people typically (currently) don’t deposit much cash that way since there is no need or reason to do so.

The reason you can have a 1 second timed deposit is the same as the reason we can have a 30 year mortgage today. Timed deposits, the vast majority of the time at least, roll over into an additional timed deposit. Very few people deposit money for 30 year terms. Certainly not enough to make possible mortgages on any useful scale (even if you limit “useful” to “economically responsible”). They do, however, often roll over their 1 year or even 3-month CDs for that long.

Tell you what, I’ll make you a loan on the following terms:

You have to pay it back in 1 second, unless there are still sufficient reserves available in rolled-over 1 second timed deposit accounts, in which case I guarantee that I will reloan the money (minus your 1-second’s worth of principle+interest payments, of course).

Naturally, if my reserves are depleted, I won’t be able to do this and you’d be stuck repaying the loan. But that only happens in a bank run. Furthermore, I (or you) can purchase insurance to cover this eventuality. That’s just a small extra increment of interest.

See… no difference from loaning demand deposits.

The reason it doesn’t help, though, is that money creation happens every time the money is loaned out. Don’t forget that the lender probably bought something with that money (i.e. demand was increased), and the seller now has that same loaned money to deposit at the same (or another bank).

It’s largely by loaning the same money out multiple times that the inflation of the money supply happens. And that happens even with what might be called 100% reserves. Indeed, the concept doesn’t even make sense in the context of a bank.

A deposit is not a loan. A loan is the exchange of present money for future money. A deposit is the exchange of present money for a claim to money, redeemable at any time.

Under fractional reserve banking (20% in the US), someone deposits $100 in a checking account and the bank will loan out 80% of it. The depositor will behave and spend as if he owns $100 in cash, and the recipient of the loan will act as if he owns $80 in cash. But no equivalent production of goods has occurred. Thus inflation ensues.

Under 100% reserve banking, if someone deposits money into a checking account, the bank can NOT loan out 80% of it. It has to keep all the deposited money untouched and available to the depositor. Thus no inflation can occur from this source.

If, under 100% reserve banking someone invests in a 10 yr CD, then the bank will indeed loan it out to someone else, and that someone else will spend it accordingly. But the depositor won’t, because his money is locked into a CD.

Thus, under 100% reserve banking no inflation can occur from these two points.

Before the loan, the depositor didn’t need the money during this time. Therefore, his present demand for goods and services (as pertains to this money) is zero. The borrower obviously does, but didn’t have the money. His present demand for goods and services is therefore (economically) also zero. After the loan, the borrower’s (economic) demand for goods and services has increased. Therefore prices increase.

But that’s not the big problem. At worst, that’s a doubling of the supply of money being actually used. The big problem is that the borrower buys something with that money (typically). The seller now has it… and is free to deposit it in a bank in a 10-year CD. And the bank is free to loan it out again. Over and over and over again. That is the majority of how the money supply is increased.

M1 doesn’t increase nearly as much as M2.

Oh, and BTW, the reserve requirement in the US isn’t 20%. It’s (complicated, but for purpose of discussion is) 10%.

Almost agree, I would only add the following remarks:

  • “Before the loan, the depositor didn’t need the money during this time.” – Not necessarily true, he is free to draw checks upon his checking deposits any time and will treat it accordingly, for example to pay his rent. Therefore his present demand is surely not 0. Even if, for the sake of your argument only, he were to not use this money in transactions, he would still TREAT it as if it was money and spend his remaining money accordingly. I outlined this in http://www.economicsjunkie.com/inflation-deflation-revisited/
  • You pointed out yourself “At worst, that’s a doubling of the supply of money being actually used.” – I agree 100%.
  • The multiplier effects you outlined below are completely accurate and are nothing but a multiplication of the example I used between 2 people. And yes I was wrong on the 20%, I meant 10% for demand deposits.
  • And all the things you outlined above would be completely prevented under 100% reserve banking, which was the point of our discussion I believe.
  • M1 and M2 are both nice approximations, but miss the point, I recommend True Money Supply for an accurate figure: http://www.economicsjunkie.com/true-money-supply/

Sorry, I wasn’t clear. What I meant was that the depositor didn’t need that money that he deposited in a timed account (the example we were using was a 10-year CD). Otherwise he wouldn’t have deposited it that way.

Here’s a comical, but illustrative, example I use to show that timed accounts (and therefore what most people seem to mean when they say “100% reserve banking”) don’t save you from the money-supply multiplying effects of banking:

I deposit $1000 in a 1 year CD. Instantly, someone borrows that $1000 and buys something from me. Instantly, I deposit (that same) $1000 in a new 1 year CD. Instantly, someone borrows that $1000 and buys something from me. Lather, rinse, repeat ad infinitum.

The fact that it’s a 1 year timed account has not prevented the money supply in this example from expanding in zero time quite literally to infinity, resulting in infinite inflation. Amusingly, my interest is also infinite over the next year, so perhaps I can afford that.

Not loaning demand deposits does slow things down a bit, I’ll admit. But that was vastly more true before computer banking, so historical examples don’t really correlate very well.

Good example you posted. It contains only one flaw: You are saying that the money supply is rising from zero to infinity. But it doesn’t, it is $1000 at the beginning and $1000 after you repeat, no matter how many times you repeat :) What you described is a perfectly legitimate chain of exchange transactions. What is being created is lots and lots of debt, claims to FUTURE money. To be sure, interest rates would rise rapidly which would precipitate an end to the borrowing sooner or later. But NO NEW MONEY IS CREATED anywhere in your chain.

If the chain of events you outlined above were to cause inflation, then the following would also create inflation:

  • I use money to buy bread from you
  • You use that money to buy an apple from me, so now I have money again
  • I take that money to buy cheese from Frank
  • Frank uses that money to buy a Frisbee from me
  • Lather, rinse, repeat ad infinitum :)

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Obama Tries to Square the Economic Circle

Just a quick and simple example to demonstrate President Obama’s tragic cluelessnes when it comes to grasping our economic problems.

In his speech on the economy on April 14th he said:

IT IS NOT SUSTAINABLE TO HAVE AN ECONOMY WHERE IN ONE YEAR 40% OF OUR CORPORATE PROFITS CAME FROM A FINANCIAL SECTOR THAT WAS BASED ON INFLATED HOME PRICES, MAXED OUT CREDIT CARDS, OVERLEVEREGED BANKS, OVERVALUED ASSETS. IT’S NOT SUSTAINABLE TO HAVE AN ECONOMY WHERE THE INCOMES OF THE TOP 1% HAVE SKYROCKETED WHILE THE TYPICAL WORKING HOUSEHOLD HAS SEEN THEIR INCOMES DECLINE BY NEARLY $2,000. THAT’S JUST NOT A SUSTAINABLE MODEL FOR LONG-TERM PROSPERITY.

Yes. An overleveraged banking system and an overleveraged economy are unsustainable. Overleveraging occurs when a business enters into more obligations than it can provide equity collateral for. Like for example a bank that makes $10 available in credit transactions for every $1 it receives. One would think that he got at least this point.

Unfortunately the teleprompter later on also made him utter the following words in that very same (!!!) speech:

ALTHOUGH THERE ARE A LOT OF AMERICANS WHO UNDERSTANDABLY THINK THAT GOVERNMENT MONEY WOULD BE BETTER SPENT GOING DIRECTLY TO FAMILIES AND BUSINESSES INSTEAD OF TO BANKS, ONE OF MY MOST FREQUENT QUESTIONS IN THE LETTERS THAT I GET FROM CONSTITUENTS IS “WHERE’S MY BAILOUT?” I UNDERSTAND THE SENTIMENT. IT MAKES SENSE INTUITIVELY AND MORALLY, BUT THE TRUTH IS THAT A DOLLAR OF CAPITAL IN A BANK CAN ACTUALLY RESULT IN $8 OR $10 OF LOANS TO FAMILIES AND BUSINESSES. THAT’S A MULTIPLIER EFFECT THAT CAN ULTIMATELY LEAD TO A FASTER PACE OF ECONOMIC GROWTH. THAT’S WHY WE HAVE TO FIX THE BANKS.

This is not a joke. He seriously said these two things in one and the same speech. I could understand if he were to hold different speeches to different interest groups and lie to each of them in a different way by appealing to their particular constituents. After all he is nothing but an average politician who knows no better than to play this game.

But what he is doing here is rooted in a much more tragic circumstance: President Obama has no clue about how precisely this fractional reserve system caused excessive credit expansion and leverage and thus created the business cycle with its inevitable culmination, the credit crunch.

He is lost in a maze of inconsistencies and won’t get out of it until he realizes that he has appointed the wrong man as Secretary Treasury and that the Federal Reserve System is inherently broken precisely because of the concept of fractional reserve banking. Just as we can’t square the circle, we simply can’t borrow, spend, and leverage our way out of too much debt, too much consumption, and too much leverage.

It didn’t work in the Great Depression. It won’t work now.

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