Tag Archive for: monetary policy

What Is Fractional Reserve Banking and Is It Good or Bad?

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After the collapse of Silicon Valley Bank (SVB), I received several questions related to the collapse. One by Dr. Michael Overfield caught my eye. He says:

“The question I have is about fractional reserve banking. This is more in the news following the failure of the Silicon Valley Bank. [Some] feel we should outlaw fractional reserve banking. This policy would assure that our banks would have our funds secure whenever any of the depositors want them. But the depositors would have to pay a fee, or negative interest rate to get this service. Additionally funds would not be available for loans for business, homes, education and other needs. I have not seen the issue of fractional reserve banking addressed in the FEE newsletter which I read daily. Thank you in advance for your consideration.”

Before I highlight what I think about fractional reserve banking (FRB) we should spend some time dissecting what it is.

Ever wondered what happens to your money when it gets deposited at the bank? Or maybe you’ve just always assumed that the bank keeps it all on hand?

Think again. When you go to the bank and put your money in, economists call this money bank deposits. Today in the United States, banks do not typically keep 100% of deposits on hand. Instead, when you deposit your money, some of it is kept in the bank, but the bank lends the rest out to borrowers looking for funds.

Economists call this system fractional reserve banking because only a fraction of total deposits are kept in the bank’s reserves. This is in contrast to full reserve banking, in which 100 percent of deposits are kept in the bank’s reserves.

To give an example of fractional reserve banking, imagine I deposit $100 in FEEBank. FEEBank can decide they want to keep 20% of my money on hand ($20) and lend out 80% ($80) for a year to earn 5% interest from a borrower.

At the end of the year when the loan expires, FEEBank earns $4 from the loan they gave and pays me 1% interest ($1) for my money.

This is a win-win-win. I earn money while my money is idle. The bank earns money on the loan. The borrower is able to borrow money at an acceptable rate.

Despite the upsides, you may have noticed a potential issue with the above example. Let’s scale the bank up a bit to see this issue manifest in a more realistic example.

Imagine FRB on a larger scale. Ten people put in $100 each for a total of $1,000 in FEEBank’s reserves. If the bank wants to keep 20% in reserves, they keep $200 on hand, and they can lend out $800.

Now imagine one customer goes in and wants to take their $100 out. FEEBank has lent out $800 of the $1000 and they have $200 on hand. They give the first customer $100 of the $200 and are left with $100.

But now say a second customer comes in and wants their $100 back too. You probably see where this is going. If the second customer withdraws all funds, the bank is left with $0 on hand.

If any other depositors come in and ask for money, the bank is in trouble. FEEBank has no way of giving depositors the money they request! They can’t simply call back the $800 loan. If this happens, FEEBank goes under. In our modern economy, regulators would come and take over bank operations and FEEBank owners would lose their investments (unless they get bailed out or can borrow the money).

So FEEBank has a decision to make when engaging in FRB. The larger the percent of deposits kept on hand, the smaller the chance that depositors will clean them out. On the other hand, having a larger percentage of deposits means banks can’t make as much money from lending.

Customers experience a trade off too. Banks are able to hold money and offer the customers interest because the bank lends out their deposits. So customers are more at risk when their banks lend out their funds, but they receive a better return.

So, given the risk to customers, should FRB be prohibited? I don’t think so. But I also think that’s the wrong question.

The bank hypothetically not being able to pay back depositors is no big issue. A lot of our financial system is built on risk. When you loan money, you may not get your money back. When you loan money through an intermediary (like a bank), it’s possible they don’t get paid back. And, so long as customers are made aware of the risk that FRBs may run out of money, I don’t see any problem with letting customers take that risk.

If we think people should be able to turn their money into poker chips at casinos, I think it’d be odd to say they shouldn’t be able to turn it into fractional bank deposits.

But, as I said, I think this is at least partly the wrong question. I do think FRBs would exist in a modern competitive system, but I can’t be sure because our banking system is not competitive.

Government facilitated deposit insurance, depositor bailouts, ballooning regulatory codes, and bailouts for banks deemed “too big to fail” make it difficult to know what the banking system would look like in the modern US absent the visible hand of government.

All of this ignores the even bigger government intervention in the world of finance—a monopoly on the production of currency. Economist Lawrence White has written extensively on both the theory and history of banking in a world with competing monies.

In a freer system, I think it would likely be easier to find banks who keep all money on hand and charge a yearly fee, similar to what Dr. Overfield mentions in his question above.

Similarly, economist Robert Murphy has proposed a full reserve system which doesn’t require yearly fees and allows for lending by having depositors agree to lock in their funds for a specific amount of time which matches with the loan maturity.

Of course, this system still runs the risk of companies not being able to pay back their loans therefore making banks unable to pay back depositors. But it is, at least, an alternative option to the somewhat bland world of banking choices available today.

In summary, I don’t find FRB to be illegitimate, ethically or economically. Businesses constantly manage and weigh risks every day that, under certain circumstances, could blow up in the faces of owners or customers.

So long as customers are not defrauded by promises of it being completely risk free, my assumption is some successful entrepreneur will be able to effectively manage the risk of fractional reserves to provide depositors with a relatively high return.

But I am bothered by how standardized the banking industry is today and how few options there are for customers. It seems unlikely to me that in a world free of layers of subsidization, regulation, and monetary monopoly that our banking system would look like it does today.

AUTHOR

Peter Jacobsen

Peter Jacobsen teaches economics and holds the position of Gwartney Professor of Economics. He received his graduate education at George Mason University.

RELATED ARTICLE: A Billionaire Progressive Has Transformed America—by Destroying It

RELATED VIDEO: How to Survive a Bank Collapse

EDITORS NOTE: This FEE column is republished with permission. ©All rights reserved.

FDR’s Other ‘Day of Infamy’: When the U.S. Government Seized All Citizens’ Gold

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Ninety years ago, Franklin Roosevelt told Americans they had less than a month to hand over their gold or face up to ten years in prison.

December 7, 1941 will forever be remembered as, in the words of Franklin Delano Roosevelt, “a date that will live in infamy.” Another infamous date is April 5, 1933—the day that FDR ordered the seizure of the private gold holdings of the American people. By attacking innocent citizens, he bombed the country’s gold standard just as surely as Japan bombed Pearl Harbor.

On this 90th anniversary of the seizure, it behooves us to recall the details of it, for multiple reasons: It ranks as one of the most notorious abuses of power in a decade when there were almost too many to count. It’s an example of bad policy imposed on the guiltless by the government that created the conditions it used to justify it. And the very fact of compliance, however minimal, is a scary testimony to how fragile freedom is in the middle of a crisis.

Suddenly on April 5, 1933, FDR told Americans—in the form of Executive Order 6102—that they had less than a month to hand over their gold coins, bullion and gold certificates or face up to ten years in prison or a fine of $10,000, or both. After May 1, private ownership and possession of these things would be as illegal as Demon Rum. After Prohibition was repealed later the same year, the sober man with gold in his pocket was the criminal while the staggering drunk was no more than a nuisance.

Hoarding gold was preventing recovery from the Great Depression, FDR declared. Government (which caused the Depression in the first place) had no choice, if you can follow the logic, but to seize the gold and do the hoarding itself. But of course, the big difference was this: In the hands of the government, huge new gold supplies could be used by the Federal Reserve as the basis for expanding the paper money supply. The President who had promised a 25 percent reduction in federal spending during his 1932 campaign, could now double spending in his first term.

What evidence suggested Americans were “hoarding” gold? Roosevelt pointed to a run on banks that immediately preceded his April 5 seizure decree. Indeed, people were showing up at tellers’ windows with paper dollars demanding the gold that the paper notes promised. But Roosevelt had prompted the bank run himself!

On March 8, three days after succeeding Herbert Hoover as the new President, FDR declared the gold standard to be safe. After all, America’s gold reserves were the largest in the world. Then out of the blue, on March 11, the President issued an executive order preventing banks from making gold payments. The message was clear: In spite of its campaign pledge to protect the integrity of the currency, this was an administration intent on spending and printing like none before. Citizens who wanted to protect their savings and financial assets suddenly had every good reason to find and keep whatever gold they could get their hands on. James Bovard writes in “The Great Gold Robbery,”

Roosevelt was hailed as a visionary and a savior for his repudiation of the government’s gold commitment. Citizens who distrusted the government’s currency management or integrity were branded as social enemies, and their gold was seized. And for what? So that the government could betray its promises and capture all the profit itself from the devaluation it planned. Shortly after Roosevelt banned private ownership of gold, he announced a devaluation of 59 percent in the gold value of the dollar. In other words, after Roosevelt seized the citizenry’s gold, he proclaimed that the gold would henceforth be of much greater value in dollar terms.

Dentists, jewelers, and industrial users were allowed to acquire gold to meet their “reasonable needs.” If you had a gold tooth, the government did not yank it out. But if you possessed more than $100 in monetary gold (coin or notes denominated in the yellow metal) after May 1, 1933, you were a villainous lawbreaker until private gold ownership was legalized four decades later.

With the passage of the Thomas Amendment to an agricultural bill on May 12, 1933, vast new presidential powers over money were affirmed by Congress. But even some of FDR’s own party still had a conscience. Democratic Senator Carter Glass of Virginia solemnly and honestly lamented,

It’s dishonor, sir. This great government, strong in gold, is breaking its promises to pay gold to widows and orphans to whom it has sold government bonds with a pledge to pay gold coin of the present standard of value. It is breaking its promise to redeem its paper money in gold coin of the present standard of value. It’s dishonor, sir.

When FDR followed up in June by abrogating the gold clauses in both private and government contracts, he asked blind Oklahoma Senator Thomas Gore, a fellow Democrat, for his opinion. Gore had lost his eyesight at the age of 12 but he saw right through FDR on this matter. He famously replied, “Why that’s just plain stealing, isn’t it, Mr. President?”

In his book, Economics and the Public Welfare, A Financial and Economic History of the United States, 1914-1946, the great economist Benjamin Anderson recalled Senator Gore’s words on the Senate floor:

Henry VIII approached total depravity, as nearly as the imperfections of human nature would allow. But the vilest thing that Henry ever did was to debase the coin of the realm. [See: “How Henry VIII Debauched English Money to Feed His Lavish Lifestyle.”

Many Americans were cowed by government threats to do the “patriotic” thing and turn in their gold as Roosevelt mandated. But true to the rugged individualism and defiance of tyranny ingrained in our culture, FDR’s order prompted widespread noncompliance. Best estimates, corroborated in this short video and elsewhere, suggest that for every one dollar in gold that Americans relinquished, they quietly kept three.

If the federal government tried today to seize the gold holdings of private American citizens, how much do you think we would turn over?

Call me a scofflaw if you want, but it would NOT get its hands on mine.

For Additional Information, See:

Great Myths of the Great Depression by Lawrence W. Reed

Media Still Peddling One of the Great Myths of the Depression by Lawrence W. Reed

The Great Gold Robbery by James Bovard

James U. Blanchard: Champion of Liberty and Sound Money by Lawrence W. Reed

FDR Campaigned on Fiscal Restraint in 1932. He Delivered Just the Opposite by Lawrence W. Reed

The Great Crash and Depression: 90 Years Later by Lawrence W. Reed

The Great Gold Robbery of 1933 by Thomas Woods

AUTHOR

Lawrence W. Reed

Lawrence W. Reed is FEE’s President Emeritus, Humphreys Family Senior Fellow, and Ron Manners Global Ambassador for Liberty, having served for nearly 11 years as FEE’s president (2008-2019). He is author of the 2020 book, Was Jesus a Socialist? as well as Real Heroes: Incredible True Stories of Courage, Character, and Conviction and Excuse Me, Professor: Challenging the Myths of Progressivism. Follow on LinkedIn and Like his public figure page on Facebook. His website is www.lawrencewreed.com.

EDITORS NOTE: This FEE column  is republished with permission. ©All rights reserved.

The Other Half of the Inflation Story

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Credit expansion adds noise to price signals by Sandy Ikeda.

More money means higher prices. It’s too bad not everyone understands that connection. Even some economists don’t get it. Readers of the Freeman do, I’m sure. And they also understand why that’s a bad thing.

Increasing the supply of money and credit, other things equal, will cause a general rise in wages and prices across an economy. When the Federal Reserve, the central bank of the United States, excessively “prints money,” the result is “inflation” as it’s now commonly called. For those who get the new money after everyone else has spent theirs, inflation means incomes will now buy fewer goods, and every dollar lent before prices rose will be worth less when it’s returned.

If inflation continues, people will eventually learn to demand more for what they sell and lend in order to compensate for the purchasing power that inflation keeps eating away. That, in turn, will cause prices to rise faster, which makes planning for households and businesses even more difficult. In the past, that difficulty has led to hyperinflation and a breakdown of the entire economic system.

But as awful as all this may be, it’s really only half the story, and perhaps not even the worse half. What follows is a highly simplified story of what happens.

The structure of production

If you’d like to build a sturdy house, you’ll need to have some kind of blueprint or plan that will tell you two things:

  1. how the frame, floor, walls, roof, plumbing, and electrical system will all fit together; and
  2. the order in which to put these components together.

Even if the house was made entirely of identical stones, you would need to know how to fit them together to form the floor, walls, chimney, and other structural components. No two stones would serve exactly the same function in the overall plan.

The economy is like a house in the sense that each of its parts, which we might call “capital,” needs to mesh in a certain way if the eventual result will be order and not chaos. But there are two big differences between a house and an economy. The first is that the economy is not only much bigger, but it consists of a multitude of “houses” or private enterprises that have to fit together orcoordinate, and so it’s an unimaginably more complex phenomenon than even the most elaborate house.

The second major difference is that a house is consciously constructed for a purpose, typically for someone to live in it. But an economic system is neither consciously designed by anyone nor intended to fulfill any particular purpose, other than perhaps to enable countless people with plans to do the best they can to achieve success. It’s a spontaneous order.

The way all the pieces of capital, from all the diverse people in the economy who own them, fit together is called the capital structure of production.

Credit expansion distorts the structure of production

When people decide to spend a certain portion of their incomes on consumption today, they are at the same time deciding to save some portion for consumption for the future. The amount that they save then gets lent out to borrowers and investors in the market for loanable funds. The rate of interest is the price of making those transactions across time. That is, when you decide to increase your saving, other things equal, the rate of interest (what some economists call the “natural rate of interest”) will fall. The falling interest rate makes borrowing more attractive to producers who invest today to produce more goods in the future.

That’s great, because when the market for loanable funds is operating freely without distortions, that means when people who saved today try to consume more in the future, there actually is more in the future for them to consume . Businesses today invested more at the lower rates precisely in order to have more to sell in the future when consumers want to buy more.

Now, if the Federal Reserve prints more money and that money goes into the loanable funds market, that will also increase the supply of loans and lower the interest rate and induce more borrowing and investment for future output. The difference here is that the supply of loans increases not because people are saving more now in order to consume more in the future, but only because of the credit expansion. That means that in the future, when businesses have more goods to sell, consumers won’t be able to buy them (because they didn’t save enough to do so) at prices that will cover all of the businesses’ costs. Prices will have to drop in order for markets to clear. Sellers suffer losses and workers lose their jobs.

And, oh yes, all that credit expansion also causes inflation.

While this process sounds rather involved, it’s still a highly simplified version of what has come to be known as the Austrian business cycle theory. (For a more advanced version, see here.) Of course, each instance in reality is significantly different from any other, but the narrative is essentially the same: credit expansion distorts the structure of production, and resources eventually become unemployed.

The explanation is more involved than the typical inflation-is-bad story that we’re more familiar with. Indeed, that probably explains why it’s the less-well-known half of the story. Even Milton Friedman and the monetarists pay little attention to the capital structure, choosing instead to focus on the problems of inflationary expectations.

Again, for Austrians, the problem arises when credit expansion artificially lowers interest rates and sets off an unsustainable “boom”; the solution is when the structure of production comes back into alignment with people’s actual preferences for consumption and saving, which is the “bust.” Most modern macroeconomists see it exactly the opposite way: the bust is the problem, and the boom is the solution.

An intricate, dynamic jigsaw puzzle

To close, I’d like to use an analogy I learned from Steve Horwitz (whom I heartily welcome back as a fellow columnist here at the Freeman).

The market economy is like a giant jigsaw puzzle in which each piece represents a unique unit of capital. When the system is allowed to operate without government intervention, the profit-and-loss motive tends to bring the pieces together in a complementary way to form a harmonious mosaic (although in a dynamic world, it couldn’t achieve perfection).

Credit expansion, then, is like someone coming along and making too many of some pieces and too few of others — and then, during the boom, trying to force them together, severely distorting the overall picture. During the bust, people realize they have to get rid of some pieces and try to discover where the others actually fit. That requires challenging adjustments and may take some time to accomplish. But if the government tries to “help” by stimulating the creation of more superfluous pieces, it will only confuse matters and make the process of adjustment take that much longer.

Inflation is bad enough. Unfortunately, it’s only half the story.

Sandy Ikeda

Sandy Ikeda is a professor of economics at Purchase College, SUNY, and the author of The Dynamics of the Mixed Economy: Toward a Theory of Interventionism.