Here's a short-ish essay I wrote today, explaining how I see the nature of fractional reserve banking, and why it's ultimately compatible with a free market.

A Defense of Fractional Reserve as the Limit of Lending

or Continuous Banking

I surprised myself recently with my own swings of opinion regarding fractional reserve banking (FRB). I initially saw nothing wrong with the practice, since there appears to be no obvious fraud or false pretense involved. There are no secrets of FRB. Every participant understands its principles, and customers are not coerced into depositing their funds. Although devices such as FDIC and central banking are obviously not compatible with free-market principles, such devices are not a requirement for fractional reserve. There is no evidence to suggest that FRB would disappear in their absence.

Later, after reading Rothbard's What Has Government Done to Our Money? and The Case for a 100% Gold Dollar, I came to think otherwise. Fractional reserve lets two or more entities lay simultaneous claim to the same unit of wealth. Since there is no associated increase in production or non-monetary holdings, this increase in the money supply in inherently inflationary. It is not real wealth, but rather the illusion of wealth. And as with all inflationary measures, FRB is subject to deflation--often rapid deflation--in the form of bank runs. It seemed clear to me that if two people are holding claims to the same unit of wealth, one or both of them must be the subject or perpetrator of fraud.

I now find myself once again supporting the existence of FRB, although this time for different reasons. What began as an indictment of FRB ultimately emerged as a defense of the very same institution. Could it be that FRB is both a sound, honest, free-market enterprise and an inherent institute of inflation? To demonstrate this possibility, I've provided simplified examples of how fractional lending can perform both functions without the involvement of fiat currency or other government involvement.

To be clear, what I'm describing below is not an accurate depiction of contemporary banking practices. I believe it is, however, a defense of fractional-reserve lending in principle.

A Simple Loan

Consider the situation wherein Steve (a fictional saver) possesses 100 ounces of gold, and wishes to put his wealth to work. Frank (a fictional farmer) is looking to expand his business, but he needs capital to do so. Steve feels that Frank's business plan is a good one, so he lends his gold to Frank for one year, at 10% annual interest. So Frank now has 100 oz. of gold to do with as he pleases, and Steve does not. At the end of a year Frank will owe Steve 110 oz. of gold.

There is a possibility that Frank will not be able to repay Steve, and this is a risk that Steve has implicitly agreed to. Of course, if Steve is smart he will have made Frank put up some kind of collateral to secure the loan. For our purposes, though, it's enough to acknowledge this possibility, and to recognize that it does not represent any kind of fraud or deceit on the part of Frank. The vagaries of his business, his skills as a farmer, current market conditions, and natural disasters will all determine whether he is able to fulfill the conditions of Steve's loan, and Steve will have taken these into account when deciding whether to make the investment.

Loaning on Leverage

Now consider the situation wherein Bob (a fictional banker) decides to get into the lending business. Bob is willing to borrow Steve's 100 oz. of gold at 10% interest, just as Frank was, but instead of using those funds himself, he will now lend that gold to someone else at a higher rate rate. Borrowers will be willing to pay Bob's premium for the flexibility of loan amounts, availability, and terms that Bob can offer but Steve cannot. As a professional lender, Bob has a competitive advantage over Steve. He develops more capital availability and a better lending reputation than Steve could as an individual.

Here Steve is a sort of depositor. However, he has no claim to his "deposit" until the end of the term (1 year). He cannot "withdraw" the 100 oz. of gold until the end of his term, and during that period he cannot even be considered to own it. He certainly cannot spend it, since it's in the hands of Bob or one of Bob's borrower clients. The best he can do is sell the loan itself, as well as its potential for default, to someone else.

The Relative Value of Term Lengths

What's described above is akin to debentures such as certificates of deposit (CDs), or the bonds issued by governments and corporations. And like these debentures, Steve's loan to Bob can take different forms. Bob will offer Steve a higher rate of interest for long-term deposits (say, 15% for ten years) than he would for short-term deposits (say, 10% for one year).

The actual numbers would of course depend on the prevailing market conditions, but in principle Bob will always pay Steve a higher interest rate for longer deposits. If Steve knows he won't need his gold for some time, he will agree to loan it to Bob for a longer time, thus getting more for his investment. If he thinks he might need it in the short-term, he'll have to settle for the lower rate of return.

The specific terms are not particularly relevant. Steve and Bob can come to any agreement they both find acceptable. During the loan period, however short or long it may be, Steve will not have access to his money, and Bob will be able to loan it out to other customers as he sees fit. Bob's outgoing loans do not have to exactly fit with Steve's depositary loan, however, because Bob can mix and match his loans in any way he chooses. He is simply obliged to meet his obligation to Steve at the end of Steve's depositary term, and whatever he does in the interim is irrelevant.

Continuous Interest

The period by which one calculates interest is critical to calculating what that interest amounts to. If Steve earns 10% on his 100 oz. of gold, and interest accrual is calculated annually, he be owed 110 oz. at the end of one year. If the interest is calculated twice a year, however, he will be owed the slightly higher amount of 110.25. If it's calculated every month, the result is 110.47, and if it's calculated every day, he will be owed 110.52. The more often this interest is calculated, the higher his result will be, although these increases are subject to diminishing returns. The formula for such periodic calculations is:

Result = Principle * (1 + Rate / Period) ^ (Time * Period)

Interest can also be calculated continuously. That is, we can calculate the interest at any given time, by calculating the limit of interest payments as our period of calculation approaches infinity. We can do that using the following formula (where 'e' is Euler's number, 2.7182818285...):

Result = Principle * e ^ (Rate * Time)

Continuous Terms

Continuous calculation of interest is well-understood, but a similar approach can be applied to the term of a loan as well. Shorter depositary loan terms offer more flexibility for the lender at the cost of lower interest rates. We can calculate these values as they approach an infinitely short period, and the result is a loan which has no period at all, but also no predefined end.

There is nothing magical about such an agreement. Steve would merely be loaning Bob his 100 oz. of gold at a relatively low interest rate, with the understanding that Steve may end his continuous loan at any time by calling it in. Until such a time as he does, however, the money is not Steve's to spend. It is, as any other type of loan, in Bob's possession.

And since it is Bob's to do with as he pleases (or at least within the terms of their agreement), Bob can also loan it out to other people. Opponents of fractional reserve banking may take issue with this, however, so let me elaborate further.

Obviously Bob can lend out money which Steve has lent him for a term of one year. He can just as clearly lend out money which Steve has only lent him for six month, one month, or even just for a single day. These sorts of loans do not differ in their natures, but merely in their length. There is no principled reason that Bob cannot loan out the money which Steve is lending him continuously--that is, with an infinitely short term--so long as Bob and Steve are both in agreement about the terms of their loan. What's important, as in any lending agreement, is that the borrower pays back the lender when he is expected to.

Is This Fraud?

Opponents of FRB will, again, likely object here. If Bob has many such agreements, and he is lending out the bulk of them to other borrowers, then he certainly will not be able to pay back all of his loans should they be called in by depositors like Steve. Of that there can be no doubt, and this is likely why the label "fraud" is being applied to Bob's practices by some of his detractors. Such critics are making a category error, however.

When Steve originally loaned his 100 oz. of gold to Frank the farmer, he was implicitly accepting that Frank might not be able to pay him back at the end of the one-year term. What Frank did with the gold in the meantime was up to him, so long as it remained within the bounds of their lending agreement. In the case of Steve and Bob, there is still a lending agreement. It will likely dictate that Bob may only use the funds to lend to qualified borrowers, and that Bob must maintain a certain reserve of funds. There is no specific term for a continuous-term loan, though, just as there is no specific interest period for a loan with continuously-calculated interest.

Bob's only requirement, per his agreement with Steve, is that he pay the balance of Steve's loan when Steve decides to call it in. He is not required, unless they otherwise agreed to such restrictions, that he perpetually be able to pay this balance; he is merely required to pay at such a point as Steve requests. In the interim, as with any loan, Bob can do with it as he pleases.

What's critically important to this point is that there is nothing underhanded taking place here. Bob and Steve both understand what's going on. Steve is implicitly agreeing to the possibility that, given the vagaries of Bob's business, Bob's skills as a banker, current market conditions, and natural disasters, Bob may not actually be able to pay Steve back when Steve asks. In such a case, as with any loan default, Steve would likely be entitled to whatever compensation he could get from Bob in his bankruptcy. As a lender himself, Steve is responsible for vetting Bob's reliability and only depositing gold with him if it appears to be a good investment.

The Judgment of a Free-Market

Opponents of FRB may, of course, believe that such a deposit is never a good investment. And while I would disagree with such people, it's not really a material concern. What Bob and Steve agree to is, in a free market, their own prerogatives. If Bob makes poor decisions as a lender, Steve is the biggest loser. Thus it is Steve's responsibility to ensure that he does not deposit his money with Bob if it represents an unacceptable level of risk. And such risk is rewarded through the relative value of the interest rates paid by Bob to Steve.

A bank with full reserves, or with fixed-term debentures, would pay relatively low interest rates compared to a bank like Bob's, where the reserves are fractional and the terms are continuous. These sorts of banks are not different in nature, but simply in degree of risk. A bank with fixed-term debentures is also prone to default. If their borrowers default, then the bank may no longer have enough liquidity to pay off it's depositors when their terms end. Such a bank--which Rothbard himself endorsed--may not be subject to "runs", but that doesn't make it immune to risk. And risk is not fraud. Rather, it is the heart of a free market.

cool Young Turk! I'm gonna print and read it. (only 1/8 of the way in the article Danny recommended yet, but yours is shorter so I'll do that first. gives one a sense of accomplishment)

Stewart,

Well thought out, well written. I don't think (after a first cursory reading) that I have any disagreement with the specifics of your argument.

Where we differ appears to me to be definitional. I would not call what you are describing as "banking" in the generally accepted understanding of that term. It certainly is not "demand account" banking, as you have clearly stated. That being so, I don't think your argument negates Rothbard's or my objections, but rather paints a picture of an entirely different business relationship, one where you have investors, not depositors.

- NonE

BTW, I've not read Rothbard's work, so I'm just going from what you said as to his points, that and what I've inferred from what others have said.

Thanks, NonE.

NonE wrote:

Where we differ appears to me to be definitional. I would not call what you are describing as "banking" in the generally accepted understanding of that term.

There is definitely a definitional difference between what we currently think of as bank accounts, and what I described in my examples. And, in fact, I acknowledged that in the beginning of my essay. But in principle they operate in identical manners. If a person thinks of a bank account (savings, checking, CDs, etc.) as being primarily a storage service, then they are under a misunderstanding. And while it's a misunderstanding that banks seem to encourage, they don't withhold the nature of their operations from anyone who asks. A deposit into a bank account is an investment, and absent government "insurance", it's an investment which is accompanied by counter-party risk.

NonE wrote:

It certainly is not "demand account" banking, as you have clearly stated.

That's not quite true. Fixed-term lending (such as a bond, or a CD, or a mortgage) are such that funds are clearly not available on demand. And that's the sort of banking which Rothbard endorses in WHGDTOM. But there is no reason why the "continuous" lending system that I illustrated above could not be used as an on-demand account.

A participant need only take a trip to the bank teller and say, "I would like to call in 1.5 oz of gold from my loan." In principle this is no different from saying, "I would like to withdraw $1500 from my savings account. Similarly, this process could be automated through electronic systems such as ATMs or debit cards.

NonE wrote:

I've not read Rothbard's work...

I think that you would really enjoy What Has Government Done to Our Money?. It's short, well-written, and demonstrates the fantastic understanding Rothbard had of money and its fundamental nature.

changed the word. To be sure, I indeed don't mean any disrespect. Hell, some of my favorite basketball players are black. I just like using that word for everybody. When I greet friends or fellow students I often say it, not meaning disrespect but trying to sound like a gangsta rapper.

NonE, I totally understand where you're coming from. I'm not trying to prescribe what a bank should or should not be. That's largely why my examples where hypothetical in nature.

But what I described is functionally equivalent to a contemporary bank. Again, I'm not saying what a bank should be, but rather I'm describing what they already are.

If you want a place to store your wealth and to write checks from, that makes perfect sense to me. But a savings account is an investment vehicle. That's why it pays interest. And again, I understand if you don't want the interest. But then a savings account isn't where you should put your money.

None of this is a secret. Savings accounts are investment vehicles, though they are traditionally very conservative ones. Banks are interested in your investment, so they do their best to convince you that your money is quite safe with them. And to the extent that the FDIC plays a role in that process, I agree with you that it's a bit crooked.

The point of my essay, however, wasn't that modern banking has no blemishes; rather it was to show that fractional reserve banking, as a principle, is compatible with a free market. If you think banks are lying to their customers, and representing themselves functionally as warehouses of wealth, rather than as the conservative investment vehicles that they are, then I think we understand each other. But I would disagree with you, because the facts are out in the open so the label of "fraud" seems hard to account for.

Stewart,

You bring up savings account... I was speaking of DEMAND account, not savings account, and so once again I find that you are obfuscating the issue. A savings account is not a demand account. I guess that where I'm having the most trouble with you is that you seem to be very loose with your definitions and to allow, like wine in a goblet on a storm tossed ship, things to slop over from one place to another with little concern for accuracy. And this seems to me to be a strange failing from one who appears to be seeking clarity. (I say this without rancor, merely as an observation.)

I do get your point that you are speaking of what you observe in the current incarnation of the banking industry rather than how we may have historically viewed the institutions. But then, isn't that similar to the problem of the word "liberal" meaning something totally different from it's etymology?

As to your last paragraph, I see your point, and yet still I disagree. Consider, if you will, that regardless of the fact that fiat fractional reserve banking is the common form of the monetary world today, the reality is that it is crashing about our knees due to it's inherent false premises. You can proclaim a god, but that does not make him real.

- NonE

I don't mean to obfuscate anything. I used a savings account as my example, but the same principal holds true for a checking account as well. They are different entities, not by their nature, but typically by the degree of interest and balance requirements that the lender and the borrower (i.e. the depositor and the bank) agree to. All the relevant facts are available in the "small print" of one's banking agreement.

NonEntity wrote:

do get your point that you are speaking of what you observe in the current incarnation of the banking industry rather than how we may have historically viewed the institutions.

Banks have been operating in this manner for hundreds of years. Banking is not warehousing, nor does it pretend to be. If you want a warehouse for your wealth--and certainly that is a reasonable desire--there is nothing stopping you from using one. Again, the agreement that one signs with a bank makes it clear enough to anyone who pays attention to what they are signing. And no one is forced to sign.

NonEntity wrote:

Consider, if you will, that regardless of the fact that fiat fractional reserve banking is the common form of the monetary world today, the reality is that it is crashing about our knees due to it's inherent false premises. You can proclaim a god, but that does not make him real.

I believe I've made this point before, but your chief complaint seems to be with fiat money. I don't think anybody around here is going to argue with you on that issue. The point of this essay is to show that fractional reserve is compatible with a free market. Additionally, as I illustrated above, it works just the same with gold or fiat dollars or silly putty.

Okay, in that case we probably agree. Are you suggesting that maybe I remove my head from my ass? But it's so dark and warm in here!

- NonE

But then (you see, I just can't let go of this, maybe I need a 12 step program for FRBers), why even have ANY reserve, or any requirement for a reserve? Surely that can be dealt with contractually. I can invest my money with you and you can take my request for a withdrawl and process it as and when it suits the investments that you've made with it. Would you then consider THIS to be banking?

- NonE

I'm not exactly sure what you're asking. If you're asking whether we need government-mandated reserve requirements, then of course I think that we don't.

NonE wrote:

I can invest my money with you and you can take my request for a withdrawl and process it as and when it suits the investments that you've made with it. Would you then consider THIS to be banking?

As you say, we can deal with this contractually. It doesn't sound like a very appealing situation for the depositor, but then I don't know why anyone would enter into such an agreement in the first place.

A bank is not contractually obligated to be able to pay all of its clients at all times. Its obligation is to pay each client at such a time as he or she requests it (within the confines of their banking agreement).

Consider, again, the farmer who takes a loan. He is not obligated to be able to pay back the loan at all times. He is merely obligated to pay it back at such a time as it is indicated in the terms of his loan. This is true for banks as well. The fact that the time is not directly specified, but is left open-ended, is a matter of agreement between the participants, not some natural law. If the bank fails to make good, then they are in default of their agreement, but until such a time they are in good standing.

I'm a little surprised that you take such issue with this voluntary system. There is no coercion involved. Although banks, like any business, may advertise themselves in a stronger light than they may deserve, their contracts are up front. I consider it a matter of course that, as long as they are not violating their contracts, banks are operating in a manner compatible with free-market principles.