The Great Depression. Another Great Depression?

[joel]

I don't see how that would be possible. Banks earn the majority of their income via interest from loans and other investments. If a bank must retain 100% of deposits in cash, it cannot in turn invest those funds to generate income.

True. But that doesn't make it impossible. It simply holds banks to the same standards that other businesses are held. It would certainly change the nature of banking and separate its functions. Demand deposits would simply become a money warehouse. If supply and demand warranted it, banks would charge customers a fee for the services and safekeeping of checking and savings accounts.

Worse yet, capital in form of loans would not be available to fund the creation and expansion of businesses, home purchases, etc.

Eliminating fractional-reserve banking would not affect the legality of fixed-term lending, because I'm only talking about on-demand obligations. If people wanted to lend money at a fixed term, they would be able to do so. Banks could still act as intermediaries for them, taking fixed term loans and making fixed term loans at higher rates. Those individuals who want to lend at interest will do so. Some may prefer to forgo interest (on some of their wealth) and keep that cash under their mattress or in a demand deposit (perhaps paying a fee for the additional security). There ought to be no impediment between supply and demand for lendable funds.

The lack of available credit (in comparison to recent years) is the single biggest factor stifling our economy currently.

But that has to do with the creditworthiness of borrowers and banks' risk tolerance. The supply of lendable funds is currently through the roof thanks to the Federal Reserve. Excess bank reserves and the monetary base is skyrocketing at unprecedented rates. 'Lack of available credit' is merely a symptom, and is not the underlying cause of our depressed economy. At the current time, we could impose 100% reserve requirements on all checking accounts and it would have little short term effect, because reserves are already around that level.

The loosening of credit standards by Freddie Mac and Fannie Mae, as well as the rapid expansion of the mortgage-backed securities industry, are the 2 main factors that may plunge the entire planet into economic peril.

From what I have heard, this was possible mainly because people believed (correctly) that the government wound not let Freddie and Fannie fail.

The type of things you are describing would not be problems if we eliminated fractional reserve banking, and held to the same standards as other businesses. If banks were prevented from this inherently fraudulent practice and forced to keep their obligations or go under, then banks would be forced to keep their standards and reliability high.

Until this year's meltdown, I've always favored less gov't. regulation and supervision, but it's obvious that our governing agencies were asleep at the wheel this go-around, particularly in the case of Fannie Mae and Freddie Mac.

But it was their implicit government privilege (as opposed to free commerce) that caused problems. And the primary cause of our current situation was the Fed pushing interest rates below the market equilibrium rates, causing imbalances in supply and demand.

But I digress! Back to your original question: do you have any ideas that would support abolishing fractional-reserve banking?

Fractional reserve banking is inherently fraudulent. The same practice has been outlawed in other types of businesses and practices (i.e., bailment law). Abolishing it would eliminate the specters of bank runs and credit expansion, which pushes interest rates below equilibrium which devastates the economy. This would go a long way to creating stability in the economy and putting us on track for sustainable growth. It would correct some of our problems of overconsumption, overindebtedness, and undersaving.

Oh, for the unitiated, "fractional-reserve banking" is just the premise that a bank does not actually keep cash on hand (reserve) in the same amount as the total of deposits.

And considering this fact with all banks together is one way to see why it is inherently fraudulent. If there is, say, $1trillion in existence in the world, and banks all together have created $10trillion in on-demand claims to dollars, then clearly banks have created multiple legal claims to the same dollars. This is fraudulent. It is this fraudulent activity (and only this) that creates the specter of bank runs.

Depositors typically don't withdraw funds at the same time as all other depositors, therefore only a "fraction" of the actual deposits are needed on any given day.

Kind of like check kiting, another fraudulent (and illegal) activity.

The difference of the fraction of cash actually on hand and the total of deposits is loaned out in order to earn interest, which is the primary income generator of bank.

In other types of businesses, this is called embezzlement, and is illegal.

[Denonymous]

OK, it's obvious you don't care for the fractional-reserve banking concept, but it happens to be the basic premise on what all modern banking systems operate. As far as limiting the reserve requirement to only demand deposits (checking accounts), owners of time deposits (primarily CD's) still have the same rights to withdraw. They just pay a penalty for doing so. They have just as much inherent right to remove their funds as any other depositor. Also, a bank's ability to lend at a given rate is a function of it's cost of funds. If a bank has to borrow at a higher rate (CD's, FHLB match funding, etc.), it has to charge a higher rate, which removes available capital from the markets due to the higher cost. It essentially makes credit less affordable, which would further damage the lower and middle classes (on the consumer side) and severely hamper the existence and creation of small businesses. This leads to a lack of available jobs and even more damage to the economy. Perhaps had the banking system started out with something similar to what you describe, it might work. But at this point, it would totally cripple the entire world economy.

But that has to do with the creditworthiness of borrowers and banks' risk tolerance. The supply of lendable funds is currently through the roof thanks to the Federal Reserve. Excess bank reserves and the monetary base is skyrocketing at unprecedented rates. 'Lack of available credit' is merely a symptom, and is not the underlying cause of our depressed economy. At the current time, we could impose 100% reserve requirements on all checking accounts and it would have little short term effect, because reserves are already around that level.

Now, the tightening of credit is partially a result of the current economy, but it's also a major factor in continuing the decline, as well as causing some of it in the first place. Any residential construction lender will tell you that many contractors have been put out of business by the refusal of a bank to renew their construction line of credit, even though performance had been as agreed. Credit worthiness actually has little, or nothing in many cases, to do with it currently, which franky I find shameful. Trust me when I tell you that I have presented loan requests in the last several months for borrowers of impeccable credit worthiness (and substantial wealth), only to have the requests denied. And, you are absolutely correct that banks have tons of excess reserves right now, but they still are not lending them out, even to those borrowers that clearly warrent the credit extension. Banking executives don't want to risk their cushy, high-paying jobs in a bad economy, so instead they will continue to keep credit tight and in turn make the economy worse.

On the Fannie Mae/Freddie Mac issue, yes, you are correct that there was always the underlying assumption that the gov't would step in if there was a crisis. However, that certainly did not relieve those agencies of the duty to manage their business in a sound manner. The PUBLIC made the reliance on gov't. backing, not the agencies themselves. 99% of mortgages are made to the standards set by those agencies so they can later be sold to the agency, or into a MBS, which used the same standards by extension. It was irresponsible of the agencies to lower standards without any regard to the fallout, and even more irresponsible of those packaging (and rating) the value of MBS. I would certainly be in favor of barring commercial banks from investing in MBS's. In my opinion, it's a bank's function to lend money, and done correctly, this function promotes growth, job creation, and other opportunities in the community. Banks should really be limited on their other investments.

But it was their implicit government privilege (as opposed to free commerce) that caused problems. And the primary cause of our current situation was the Fed pushing interest rates below the market equilibrium rates, causing imbalances in supply and demand.

I can't really disagree with this one. There can be arguments made for and against the Fed maintaining rates so low, but I try to keep my discussion down to practical elements.

And considering this fact with all banks together is one way to see why it is inherently fraudulent. If there is, say, $1trillion in existence in the world, and banks all together have created $10trillion in on-demand claims to dollars, then clearly banks have created multiple legal claims to the same dollars. This is fraudulent. It is this fraudulent activity (and only this) that creates the specter of bank runs.

"Fraud" is a legal term, and fractional-reserve banking is clearly within the law. Therefore, it cannot be fraudulent. Irresponsible, maybe, but not fraudulent. Also, bank runs are not caused by fractional-reserve banking. They are caused by a widespread lack of faith by a bank's depositors in the continued solvency of said bank. Plus, deposits are insured against loss by the FDIC (within limits, of course). Anyone with less than $250k in any one bank has little to worry about, and little reason to participate in a "run on the bank".

Kind of like check kiting, another fraudulent (and illegal) activity.

Kiting is essentially spending funds you don't really have, with loss ending up on the bank if the check isn't covered at some point. Banks clearly DO have the funds to lend out; they've been loaned to the bank by depositors.

In other types of businesses, this is called embezzlement, and is illegal.

The practice of not carrying enough cash on hand (reserves) to meet ALL CASH OBLIGATIONS that could possibly arise TODAY is certainly not embezzlement, and we've already addressed the legality issue. You might not agree with the concepts, but it is all clearly legal.

Joel, you have some good ideas here. I like the way you've thought this through. We just can't go back a few hundred years and change the most fundamental principle of modern banking. "Bank runs" would seem to be the major argument behind increased reserve requirements, but this is largely stemmed by the insurance provided by the FDIC (at least with respect to depositor risk). Runs still happen, and unfortunately we're likely to see more of them this year, though I hope I'm wrong about that. At any rate, the overwhelming majority of depositors will still get all their funds.

I'm worn out now......

[Augustine2004]

OK, it's obvious you don't care for the fractional-reserve banking concept, but it happens to be the basic premise on what all modern banking systems operate. [snip]Perhaps had the banking system started out with something similar to what you describe, it might work. But at this point, it would totally cripple the entire world economy.

Just because people do stuff doesn’t make it right. Many banks are robbed, therefore it is a good thing.

As for the idea that fractional-reserve credit is a boon to the economy, you really have to compare to a world that has only 100% reserves and show that the fractional world would be better off. You need to take into account the possibility of black-swan events causing bank runs, like what we had last year.

those borrowers that clearly warrent the credit extension.

Are you saying that some credit-worthy people don’t get credit when they ask for it? Evidence, please, if so.

I can't really disagree with this one. There can be arguments made for and against the Fed maintaining rates so low, but I try to keep my discussion down to practical elements.

Just what does that mean, and don’t you need to decide which argument is the better one?

You clearly think that as the boom continues the economy gets better and as the bust continues the economy gets worse. That’s not the view of Austrian school economists. They believe that as the boom continues malinvestments accumulate. One could say the economy gets sicker. The bust begins when the malinvestments finally cause the economy to collapse, like a puff of air causes the house of cards to collapse. The time when the economy begins to heal itself - provided that the government keeps its cotton pickin’ hands off - is during the BUST.

The economy should be able to grow without loans. You’re overrating the importance of loans, though I concede that the economy might grow faster in a sound manner with loans.

Don’t you think the FDIC is undercapitalized now?

"Fraud" is a legal term, and fractional-reserve banking is clearly within the law. Therefore, it cannot be fraudulent. Irresponsible, maybe, but not fraudulent.

Are you not going to say it’s immoral?

[joel]

Thanks for thinking through and discussing this with me.

OK, it's obvious you don't care for the fractional-reserve banking concept, but it happens to be the basic premise on what all modern banking systems operate.

Yes, I realize I am proposing a drastic change of the banking industry.

As far as limiting the reserve requirement to only demand deposits (checking accounts), owners of time deposits (primarily CD's) still have the same rights to withdraw. They just pay a penalty for doing so. They have just as much inherent right to remove their funds as any other depositor.

This may be a gray area, because it's still effectively an on-demand deposit, but with a penalty. Perhaps banks would be required to hold only the balance minus the penalty. Basically, required to hold the amount that is payable on demand.

Also, a bank's ability to lend at a given rate is a function of it's cost of funds. If a bank has to borrow at a higher rate (CD's, FHLB match funding, etc.), it has to charge a higher rate, which removes available capital from the markets due to the higher cost.

How does it remove capital? Where would it go? under someone's mattress? Or destroyed somehow?

It essentially makes credit less affordable, which would further damage the lower and middle classes (on the consumer side) and severely hamper the existence and creation of small businesses. This leads to a lack of available jobs and even more damage to the economy.

I think we have differing understandings of interest. Interest rates (assuming they are left free to adjust) would balance supply and demand. If they are held below that rate, then that causes disaster, such as creating unsustainable business expansion. If they are too high, then people will be incentivised to lend more and push the rates down. This causes borrowing (and investment of the borrowed funds) to match consumer demands.

On the Fannie Mae/Freddie Mac issue, yes, you are correct that there was always the underlying assumption that the gov't would step in if there was a crisis. However, that certainly did not relieve those agencies of the duty to manage their business in a sound manner. The PUBLIC made the reliance on gov't. backing, not the agencies themselves.

But businesses respond to the public. It is the nature of businesses to give the consumers what they want. Because the public relied on government backing, they were willing to buy anything from Freddie and Fannie. Freddie and Fannie acted accordingly, knowing the public would buy anything. The free-market forces that would have kept the businesses managed in a sound manner were removed. (Not to mention interest rates being held below equilibrium.) The solution is to free up the market, not to add more regulation.

"Fraud" is a legal term, and fractional-reserve banking is clearly within the law. Therefore, it cannot be fraudulent.

Oh, come on. "Fraud" is a perfectly good English word. Dictionary.com defines it as "deceit, trickery, sharp practice, or breach of confidence, perpetrated for profit or to gain some unfair or dishonest advantage." And we're talking about what the law should be. Even if no fraud were illegal I would still affirm that the same activity is fraud, and argue that it should be made illegal. But if it bothers you, then you can suggest a different word. "Irresponsible" does not provide the right distinction, because it does not mean the same thing. Not all irresponsible behavior should be illegal.

Also, bank runs are not caused by fractional-reserve banking. They are caused by a widespread lack of faith by a bank's depositors in the continued solvency of said bank.

And a correct lack of faith! The bank is indeed insolvent if it cannot possibly pay its obligations. For hundreds of years people have put the blame of bank runs on the depositors. But they are simply making legal claims. It need not even be caused by panic. All the bank customers could rationally decide to get together and claim their property on the same day. That a bank cannot meet its obligations indicates that it is insolvent and the bank is not worthy of the depositors' faith.

Plus, deposits are insured against loss by the FDIC (within limits, of course).

FDIC should be eliminated too. (And would have no function without fractional-reserve banking.) FDIC creates moral hazard, removing the market forces that keep a bank responsible.

Kind of like check kiting, another fraudulent (and illegal) activity.

Kiting is essentially spending funds you don't really have, with loss ending up on the bank if the check isn't covered at some point. Banks clearly DO have the funds to lend out; they've been loaned to the bank by depositors.

But I could do the same thing with checks. I could write the checks when I do have enough balance in the account, but then (for example) lend out the same balance to someone else.

But--correct me if I'm wrong (since you are a banker)--my understanding is that banks do not even have to lend out actual money deposited. They simply have to maintain the minimum ratio of reserves to deposits (at least on checking accounts). So (with a 10% reserve requirement) if Alice (or a group of people) deposits an additional $100 in cash, then the bank can create $900 of new deposits. For example, Bob comes along and wants a loan, so the bank creates an additional savings account balance of $900 in Bob's name, in exchange for his promise to repay according to some schedule. That is, only $100 of actual cash came in, and the bank created $900 additional deposits on top of the $100 deposit. But this is no difference than check kiting, if I were to have a checking account balance of $100, and then wrote checks totalling $1000, believing that they won't all be cashed at the same time.

The practice of not carrying enough cash on hand (reserves) to meet ALL CASH OBLIGATIONS that could possibly arise TODAY is certainly not embezzlement,

So, am I not obligated to keep a checking account balance high enough to meet all outsanding checks (on-demand obligations)?

The average bank customer is under the impression that the balances in their checking and savings accounts is "their money." But, on average, 9 other people think the same money is their money too, for the same reason. For example, if Alice deposits $100, then she believes she owns $100. If the bank lends out $90 of that to Bob, then the bank has assigned title to the same $90 to two different people.

Also, embezzlement is "to appropriate fraudulently to one's own use, as money or property entrusted to one's care." (again, dictionary.com) Alice deposits her money in her demand account ostensibly for safekeeping of her property. The bank appropriates Alice's money entrusted to the banks care, for the bank's own use in making a profit by lending it to someone else.

It is not clear to all depositors that the law does not agree that it is their money. It is not money at all, but simply a promise to pay money, on demand. When I deposit $100 in my savings account, I do not really (legally) have $100 in the bank. I no longer own $100; the bank is the legal owner of it, and may do with it what it pleases. The law treats it as a loan. But this is not clear to all depositors. Even if it were, it is still effectively a loan that is daily maturing. It is not an obligation that could arise today. It is an obligation that daily matures--an obligation whose due date is today.

We just can't go back a few hundred years and change the most fundamental principle of modern banking.

Why "can't"? As I pointed out before, America used to have the same problems with, for example, grain elevators. But we codified bailment law, and solved those problems.

"Bank runs" would seem to be the major argument behind increased reserve requirements

It is not my primary argument. My main concern is the devastating effects of credit expansion itself.

[Denonymous]

But--correct me if I'm wrong (since you are a banker)--my understanding is that banks do not even have to lend out actual money deposited. They simply have to maintain the minimum ratio of reserves to deposits (at least on checking accounts). So (with a 10% reserve requirement) if Alice (or a group of people) deposits an additional $100 in cash, then the bank can create $900 of new deposits. For example, Bob comes along and wants a loan, so the bank creates an additional savings account balance of $900 in Bob's name, in exchange for his promise to repay according to some schedule. That is, only $100 of actual cash came in, and the bank created $900 additional deposits on top of the $100 deposit. But this is no difference than check kiting, if I were to have a checking account balance of $100, and then wrote checks totalling $1000, believing that they won't all be cashed at the same time.

OK, this may be where you're getting your bias against the concept of fractional-reserve banking. This is absolutely INCORRECT. A bank can only lend out what is actually on deposit. You can't take a $100 deposit and make a $900 loan. On a small community bank scale, if you have $100,000,000 on deposit, you would typically wish to have $75-80,000,000 in loans (75-80% Loan to Deposit ratio). A bank doesn't "create" any fictional deposits to lend out, such as your "Bob" example above. I totally agree that would be a pretty screwed-up way of doing business! Try rethinking some of this now with the correct premise and maybe my answers will make a bit more sense to you.

Hopefully that takes care of it, but I'll go ahead and address a couple other things:

Also, a bank's ability to lend at a given rate is a function of it's cost of funds. If a bank has to borrow at a higher rate (CD's, FHLB match funding, etc.), it has to charge a higher rate, which removes available capital from the markets due to the higher cost.

How does it remove capital? Where would it go? under someone's mattress? Or destroyed somehow?

Essentially, yes! The funds may as well stay under someone's mattress if the bank can't loan a portion of it out. I don't understand where you think a bank can obtain money to loan if it has to maintain reserves equal to it's deposits.

I think we have differing understandings of interest. Interest rates (assuming they are left free to adjust) would balance supply and demand. If they are held below that rate, then that causes disaster, such as creating unsustainable business expansion. If they are too high, then people will be incentivised to lend more and push the rates down. This causes borrowing (and investment of the borrowed funds) to match consumer demands.

The first part of this is correct, but I don't understand the logic of the second part. If loan rates are high, how is there an incentive to lend more money? The bank obviously would want to lend funds at the higher rates, but borrowers will be less motivated to borrow, and credit will be less affordable, which always cuts the lower and lower-middle classes out of the mix, which I think is a horrible social problem most of our leaders don't want to address. From a lender's perspective (me), it's always easy to loan money when rates are low and difficult when rates are high.

But businesses respond to the public. It is the nature of businesses to give the consumers what they want. Because the public relied on government backing, they were willing to buy anything from Freddie and Fannie. Freddie and Fannie acted accordingly, knowing the public would buy anything. The free-market forces that would have kept the businesses managed in a sound manner were removed. (Not to mention interest rates being held below equilibrium.) The solution is to free up the market, not to add more regulation.

It sounds like maybe you don't have a good understanding of what Freddie and Fannie's purpose was (is, maybe). The public doesn't "buy" anything from them. They were created to provide additional capital to the mortgage markets so more people could achieve home ownership. Under my explanation above, banks literally run out of money to lend. The agencies buy mortgages from lenders so they continue the business of lending. To be eligible for purchase, a mortgage has to fit "in the box" of requirements the agencies require. This previously was a pretty conservative box (down payments, Debt to income (DTI) ratios of 30%, fixed rates, documented income verification, etc). In the recent past, the box became more like a stadium (adjustable rate mortgages, no down payment, "stated income" programs, sub-prime for the credit impaired, and on and on). This incents lenders to conform to these programs and make more loans, thereby earning more income. Also, since the lenders know they don't have to keep the loan, they really don't care if it's a bad loan or not. It doesn't take a banker to realize this concept is a bad idea! Most "on the street" bankers have known (or at least suspected) for some time that there was going to be housing/mortgage bust, but I'm not sure anyone knew it would be this bad and would have so many ancillary consequences. Now, I was a free-marketeer pretty much up until 2 months ago, but the fact here is that the agencies required some effective oversight, but everyone was asleep at the wheel. There's going to have to be more effective regulatory supervision (not MORE, just more effective) of industries and entities that are critical to our economy. The simple fact is that people in power were getting rich and no one wanted to crash the party and do what was right. Do some reading on the Bernie Madoff hedge fund scandal. Pathetic lack of action from the SEC.

Hopefully this helps. I'll be around if you have more for me!

Denon

[joel]

OK, this may be where you're getting your bias against the concept of fractional-reserve banking. This is absolutely INCORRECT. A bank can only lend out what is actually on deposit. You can't take a $100 deposit and make a $900 loan. On a small community bank scale, if you have $100,000,000 on deposit, you would typically wish to have $75-80,000,000 in loans (75-80% Loan to Deposit ratio). A bank doesn't "create" any fictional deposits to lend out, such as your "Bob" example above. I totally agree that would be a pretty screwed-up way of doing business! Try rethinking some of this now with the correct premise and maybe my answers will make a bit more sense to you.

Okay, I'll assume you are right, and that banks can't legally get to this state in one step. But still they can get to such a state in multiple steps.

E.g.,
Alice deposits $100 of physical cash,
Bank lends $90 to Bob, who uses it to buy something from Charlie.
Charlie deposits the $90 in his own account. Bank now has deposits totalling $190, and $100 reserves.
Bank lends out $81 to Doug (bank has deposits $190 and reserves of $19, so still meeting reserve ratio)
Doug buys something from Frank.
Frank deposits the $81 in his own account. Bank now has deposits totalling $271, and $100 reserves.
Bank can now lend out $72.90.
This continues until the bank has deposits totalling $1000, and reserves of $100, though only the original $100 of physical cash actually exists.)
This is the source of the "money multiplier."

In the example from my previous post, I had thought banks could get there in a single step, and you may be correct that they cannot.
But now consider the following example, that could accelerate the process:
Alice deposits $100 of physical cash.
Bank lends $90 to Bob, but instead of handing $90 of physical cash to him, the bank simply increments Bob's checking account by $90. (Or alternatively, creating the same effect, the bank lends Bob the $90 in physical cash, and then Bob immediately deposits it in his own account because he does not need to spend it all at once.)
Now bank has $190 in deposits, and $100 reserves and can lend out an additional $81.

The bank could even lend the $81 to Bob, who deposits in his account immediately, and the bank now has deposits of $271 and reserves of $100 and can lend out an additional $72.90. They could keep going, lending to Bob. Suppose all this happens in Bob's one visit to the bank. The effective result is not practically any different than simply lending to Bob $900 in one step, as in my example in my previous post.

So where am I making a mistake?

Also you call this a "fictional" deposit, but how is it fictional? Or, rather, how is it any more fictional than, say, Charlie's deposit in the first example in this post?

I don't understand where you think a bank can obtain money to loan if it has to maintain reserves equal to it's deposits.

The problem is that modern banking confuses and mixes two separate functions. The first is simply safeguarding/warehousing money. The second is intermediary lending. An intermediary lender takes loans (not on-demand deposits) and loans the same out to others at a higher rate. Banks would still be allowed to act as intermediary lenders.

If loan rates are high, how is there an incentive to lend more money?

For the similar reason that higher prices increase quantity supplied. If interest is higher people (and businesses) will lend more instead of making other use of their wealth. For example, suppose you have a business project that will make a 5% return. But if interest rates rise to 6%, then you will put your business project on hold and lend your capital at 6% instead. Thus a rise in interest rates will make more people want to lend more money. If this rise in interest was a rise to a point above equilibrium, then this additional lending will (as an increase in supply) push the interest rates back down toward equilibrium. (Another thing pushing it back down toward equilibrium is (as you point out) that borrowers will be less motivated to borrow.) But an interest rate rise can also be a movement upward toward equilibrium, in which case the increased willingness to lend and decreased willingness to borrow serves to bring the two towards balance, rather than serving to push the rate back down.

borrowers will be less motivated to borrow, and credit will be less affordable, which always cuts the lower and lower-middle classes out of the mix, which I think is a horrible social problem most of our leaders don't want to address.

This is the same complaint that others make generally about free markets. If the equilibrum price of anything (say, housing) rises, then people complain that this cuts the lower classes out of the mix. But price controls make the situation even worse, because they create an imbalance between supply and demand.

From a lender's perspective (me), it's always easy to loan money when rates are low and difficult when rates are high.

Of course, because (all else being equal) it means a greater supply of lendable funds and a decreased eagerness to borrrow. Similar to what happens when the price for a commodity rises. Market forces will tend toward balancing the two, pushing rates toward an equilibrum. If interest rates are manipulated toward a point below the market equilibrium, then it becomes artificially easy to loan money.

It sounds like maybe you don't have a good understanding of what Freddie and Fannie's purpose was (is, maybe). The public doesn't "buy" anything from them. They were created to provide additional capital to the mortgage markets so more people could achieve home ownership. Under my explanation above, banks literally run out of money to lend. The agencies buy mortgages from lenders so they continue the business of lending.

Doesn't/didn't the public buy from them things like mortgage-backed-securities? The public bought the same loans in a repackaged form.
And that's where the agencies get this "additional capital." If no one bought anything from F&F, then there would not be a source of additional capital.

This incents lenders to conform to these programs and make more loans, thereby earning more income. Also, since the lenders know they don't have to keep the loan, they really don't care if it's a bad loan or not. It doesn't take a banker to realize this concept is a bad idea!

But the lenders can continue this practice only if they have the virtual guarantee that F&F will buy the loans. But this guarantee can continue only if F&F have a virtually unlimited supply of additional capital, which it can have only by reselling the same loans (repackaged) to others (or by getting subsidized or bailed out by the government). This guaranteed supply of purchasers exists only if F&F guarantees the loans and the public continues to trust F&F's guarantees. And this occurred only because of the implicit government guarantee.

So, again, I see no reason to 'fix' the problem with more/different regulation, when government intervention was the source of the problem. Without the implicit government guarantee, then the public would have (correctly) lost confidence earlier on, and F&F would have gone under (or changed their practices) early on, and lenders would have been forced (by free-market forces) to act more responsibly.

Most "on the street" bankers have known (or at least suspected) for some time that there was going to be housing/mortgage bust, but I'm not sure anyone knew it would be this bad and would have so many ancillary consequences.

The 'Austrian' economists were (for several years) publicly saying it would be. And they were laughed at.

[Denonymous]

OK, I'll play along just a little longer, but I have limited time, so I can't keep this up for long.

Okay, I'll assume you are right, and that banks can't legally get to this state in one step. But still they can get to such a state in multiple steps.
E.g.,
Alice deposits $100 of physical cash,
Bank lends $90 to Bob, who uses it to buy something from Charlie.
Charlie deposits the $90 in his own account. Bank now has deposits totalling $190, and $100 reserves.
Bank lends out $81 to Doug (bank has deposits $190 and reserves of $19, so still meeting reserve ratio)
Doug buys something from Frank.
Frank deposits the $81 in his own account. Bank now has deposits totalling $271, and $100 reserves.
Bank can now lend out $72.90.
This continues until the bank has deposits totalling $1000, and reserves of $100, though only the original $100 of physical cash actually exists.)
This is the source of the "money multiplier."

In the example from my previous post, I had thought banks could get there in a single step, and you may be correct that they cannot.
But now consider the following example, that could accelerate the process:
Alice deposits $100 of physical cash.
Bank lends $90 to Bob, but instead of handing $90 of physical cash to him, the bank simply increments Bob's checking account by $90. (Or alternatively, creating the same effect, the bank lends Bob the $90 in physical cash, and then Bob immediately deposits it in his own account because he does not need to spend it all at once.)
Now bank has $190 in deposits, and $100 reserves and can lend out an additional $81.

The bank could even lend the $81 to Bob, who deposits in his account immediately, and the bank now has deposits of $271 and reserves of $100 and can lend out an additional $72.90. They could keep going, lending to Bob. Suppose all this happens in Bob's one visit to the bank. The effective result is not practically any different than simply lending to Bob $900 in one step, as in my example in my previous post.

So where am I making a mistake?

Also you call this a "fictional" deposit, but how is it fictional? Or, rather, how is it any more fictional than, say, Charlie's deposit in the first example in this post?

Your assumptions regarding the process are still incorrect. Any deposit to a bank, regardless of the source (even if it came from loan proceeds from the same bank) still requires it's own reserve. Plus, you seem to be treating money like a good that is consumed. It keeps getting reused, whether that's in the form of new loans, or more groceries from the grocery store. Just because it's reused doesn't mean you've created more of it. Rather than dealing in economic theory, the best way to understand this may be from a practical accounting standpoint:

A community bank obtains $100 million in deposits (carried as liabilities on the balance sheet). Just for the sake of argument we'll say that $40 million is in DDA's and $60 million in CD's of different maturities. Over time, the bank lends out $75 million in loans. Some loans will be term loans, some revolving, and others demand notes. At this point, our assets consist of the $75 million in loans and $25 million in liquidity (cash). As I explained before, all depositors, regardless of demand or time account type, have the right to withdraw their funds. In this scenario, the bank can only come up with 25% of that total IMMEDIATELY. It does, however, have other avenues for cash. Most banks have credit lines established that can be drawn upon, ownership can inject more capital, and loans can be sold to other lenders. Also, demand loans can be called in. In the unfortunate event that these steps are not sufficient, the FDIC steps in to take over the bank and liquidate the assets so that all depositors are paid. Shortfalls are covered by the FDIC insurance. The "money multiplier" effect is an economic concept, and I am going to keep my explanations out of the theoretical realm. I would, however, suggest you do some reading up on it. It has nothing to do with banks "manufacturing" or "multiplying" funds, but with the EFFECT that fractional-reserve banking has as money works it's way through the economy.

Also you call this a "fictional" deposit, but how is it fictional? Or, rather, how is it any more fictional than, say, Charlie's deposit in the first example in this post?

This was your example: So (with a 10% reserve requirement) if Alice (or a group of people) deposits an additional $100 in cash, then the bank can create $900 of new deposits. For example, Bob comes along and wants a loan, so the bank creates an additional savings account balance of $900 in Bob's name, in exchange for his promise to repay according to some schedule. That is, only $100 of actual cash came in, and the bank created $900 additional deposits on top of the $100 deposit.

You have $100 deposited and $900 being loaned out, which cannot be done. The bank cannot "create" a $900 deposit from $100. If they did, this would be fictional (fraud). $100 comes in, approximately $75-80 will be loaned out (on a much simpler and smaller scale than reality, obviously).

The problem is that modern banking confuses and mixes two separate functions. The first is simply safeguarding/warehousing money. The second is intermediary lending. An intermediary lender takes loans (not on-demand deposits) and loans the same out to others at a higher rate. Banks would still be allowed to act as intermediary lenders.

Banks do not confuse their functions. Like any other business, their function is to make profit. A bank is NOT an intermediary lender. I don't have time to explain that term, but if you'll just do a google search you should find some examples. If banks had to borrow the funds they used for lending, it would increase the cost of borrowing for everyone. In my previous small bank example, let's say the $60 million of CD's have an average rate of 3% and the DDA's are paid no interest. This equates to a money cost of $1.8 million annually, or 1.8%. A bank has overhead in the form of salaries, facilities, FDIC premiums, allowance for loan losses, etc. So, the bank decides it must charge 6% for a secured loan to be profitable. If the bank was forced to borrow from some other source, it's cost of funds might be 4.5%, which results in a rate of 8.7% to maintain the same profitability. 2.7% makes a HUGE difference in payments for a sizeable term loan, leaving it unaffordable now for many that could swing it previously.

For the similar reason that higher prices increase quantity supplied. If interest is higher people (and businesses) will lend more instead of making other use of their wealth. For example, suppose you have a business project that will make a 5% return. But if interest rates rise to 6%, then you will put your business project on hold and lend your capital at 6% instead. Thus a rise in interest rates will make more people want to lend more money. If this rise in interest was a rise to a point above equilibrium, then this additional lending will (as an increase in supply) push the interest rates back down toward equilibrium. (Another thing pushing it back down toward equilibrium is (as you point out) that borrowers will be less motivated to borrow.) But an interest rate rise can also be a movement upward toward equilibrium, in which case the increased willingness to lend and decreased willingness to borrow serves to bring the two towards balance, rather than serving to push the rate back down.

So, if you own a trucking company, and interest rates are high, you will instead begin the business of loaning money to others rather than invest in more trucks??? You're logic is flawed here. Businesses succeed when they have an area of expertise and stick with that, and all good business people understand this. Neither people nor businesses are motivated to lend money when interest rates are high. They might be motivated to invest excess liquidity in an interest-based investment (CD's), but they will not (and should not) enter into an activity that they have no expertise in and that represents substantial risk (lending).

This is the same complaint that others make generally about free markets. If the equilibrum price of anything (say, housing) rises, then people complain that this cuts the lower classes out of the mix. But price controls make the situation even worse, because they create an imbalance between supply and demand.

I assume by "price control" you're referring to the very low rates that the Fed kept in place, and you may be right about that. However, Greenspan and Bernanke are far smarter than I when it comes to the effect of rates on the markets. That doesn't make them RIGHT, though. I would like to leave you with a couple thoughts on serving the lower classes. Not saying they're right, but just want you to have some perspective on it. In our example of housing, a builder typically earns 12-15% margin on a home. It's more difficult to manage construction of numerous homes, so it makes sense to build fewer, bigger homes as long as demand exists. Therefore, a builder is incented to earn more margin if he undertakes building a smaller home, raising the proportional price on the lower or lower-middle class, which is the class that can least afford to pay the additional margin. Similarly, on the lending side, it's much easier to make one $5 million loan rather than 50 $100,000 loans for affordable homes. So, the only incentive for the lender to undertake the 50 loans is if the margin is significantly higher, again raising the effective cost of a loan for those least able to afford it. Another factor not regularly considered is that the bigger loans (wealthier borrowers) draw the most talented loan officers/bankers. This leaves the less talented and well-trained lenders to deal with the smaller borrowers, who could probably benefit more by dealing with a more experienced officer than the wealthy people. Again, I'm not arguing against a free market, just pointing out some consequences of how things really work out here.

Of course, because (all else being equal) it means a greater supply of lendable funds and a decreased eagerness to borrrow. Similar to what happens when the price for a commodity rises. Market forces will tend toward balancing the two, pushing rates toward an equilibrum. If interest rates are manipulated toward a point below the market equilibrium, then it becomes artificially easy to loan money.

Keep in mind that money isn't a commodity that is produced in greater supply when demand increases.

Doesn't/didn't the public buy from them things like mortgage-backed-securities? The public bought the same loans in a repackaged form.
And that's where the agencies get this "additional capital." If no one bought anything from F&F, then there would not be a source of additional capital.

Close enough, yes.

But the lenders can continue this practice only if they have the virtual guarantee that F&F will buy the loans. But this guarantee can continue only if F&F have a virtually unlimited supply of additional capital, which it can have only by reselling the same loans (repackaged) to others (or by getting subsidized or bailed out by the government). This guaranteed supply of purchasers exists only if F&F guarantees the loans and the public continues to trust F&F's guarantees. And this occurred only because of the implicit government guarantee.

So, again, I see no reason to 'fix' the problem with more/different regulation, when government intervention was the source of the problem. Without the implicit government guarantee, then the public would have (correctly) lost confidence earlier on, and F&F would have gone under (or changed their practices) early on, and lenders would have been forced (by free-market forces) to act more responsibly.

Again, I'm not arguing for more regulation or more government. I was long a "Reaganomics" fan! Gov't. intervention didn't cause any problem at F&F. Just because an agency has the implicit backing of the gov't. doesn't make it OK for that agency to totally screw things up. They were considered too big to fail, a phrase that has now been applied to AGI and others. Heck, by that standard, there are many companies now that have the implicit backing of the gov't! You also have to keep in mind that F&F doesn't/didn't operate as a traditional free market business; they in effect have had a sanctioned monopoly. Any entity that holds this kind of power and importance to the financial markets has to have more rigorous regulatory safeguarding. F&F doesn't guarantee mortgages; they just buy them if they conform. Insurance is written through independent companies against losses on the morgages when the LTV exceeds 80% (PMI). My point on the supervisory front is that our regulatory agencies should have stepped in 4-5 years ago and called for more prudent mortgage standards. That being said, we live in a time where the financial markets are extremely complex and I'm not sure anyone really knew what effect that lack of guidance would have.

Most "on the street" bankers have known (or at least suspected) for some time that there was going to be housing/mortgage bust, but I'm not sure anyone knew it would be this bad and would have so many ancillary consequences.
The 'Austrian' economists were (for several years) publicly saying it would be. And they were laughed at.

Again, I'm not an economist, but they definitely called that one correctly.

Back to fractional-reserve banking: hopefully we've established that banks lend a portion of funds that they ACTUALLY TAKE IN. They maintain reserves and other access to liquidity sufficient to cover any reasonably expected calls for cash (this is regulated and examined by the FDIC btw). A "run on the bank" that exceeds the liquidity will only come from a widespread belief of depositors that the bank will go out of business, or that the nation's economy will totally collapse, in which case we're all screwed. As long as that last event doesn't happen and the U.S. isn't taken over by the Taliban, depositors are covered up to $250,000 by the FDIC. I don't see from here how any of this is "fraudulent", or even a bad idea. I don't know any bank customers who aren't aware the bank loans out the deposits. The system allows easier, cheaper access to credit, safety of deposited funds, and the funds are guaranteed by the full faith of the U.S. government. Now, the maintaining of very low rates by the Fed, thereby flooding the market with cheap money, has caused some disastrous effects, though there were numerous contributing factors. Hindsight is always 20/20.

[joel]

OK, I'll play along just a little longer, but I have limited time, so I can't keep this up for long.

No pressure. Whatever you have time for.

Your assumptions regarding the process are still incorrect. Any deposit to a bank, regardless of the source (even if it came from loan proceeds from the same bank) still requires it's own reserve. Plus, you seem to be treating money like a good that is consumed. It keeps getting reused, whether that's in the form of new loans, or more groceries from the grocery store. Just because it's reused doesn't mean you've created more of it. Rather than dealing in economic theory, the best way to understand this may be from a practical accounting standpoint:

A community bank obtains $100 million in deposits (carried as liabilities on the balance sheet). Just for the sake of argument we'll say that $40 million is in DDA's and $60 million in CD's of different maturities. Over time, the bank lends out $75 million in loans. Some loans will be term loans, some revolving, and others demand notes. At this point, our assets consist of the $75 million in loans and $25 million in liquidity (cash). As I explained before, all depositors, regardless of demand or time account type, have the right to withdraw their funds. In this scenario, the bank can only come up with 25% of that total IMMEDIATELY. It does, however, have other avenues for cash. Most banks have credit lines established that can be drawn upon, ownership can inject more capital, and loans can be sold to other lenders. Also, demand loans can be called in. In the unfortunate event that these steps are not sufficient, the FDIC steps in to take over the bank and liquidate the assets so that all depositors are paid. Shortfalls are covered by the FDIC insurance.

It is not clear to me how my assumptions are incorrect. I understand and agree everything you are saying here. What I'm talking about is what happens next, when you follow this example forward. So the bank has $100million in deposits (liabilities) and $100million in assets ($75 million in loans and $25million in cash). Now, those who borrowed the $75million will purchase things with it. Indeed, that is why they borrowed money. The sellers of the things purchased will then hold the $75million (say, in cash). They bring this $75million back to the bank to deposit into their own savings accounts. Now the bank has $175M in liabilities (deposits), and $175M in assets ($100M in cash, and $75M in loans). But, we have not introduced any new physical cash (there's only $100M in this example).

So already the effective money supply has increased, because the deposits ($175M) exceed the amount of physical cash ($100M). Please point out any mistake I am making thus far.

And this can continue even further, because the bank, at this point has a 100/175 = 57% reserve ratio, and can now make additional loans.

So, if you own a trucking company, and interest rates are high, you will instead begin the business of loaning money to others rather than invest in more trucks??? You're logic is flawed here. Businesses succeed when they have an area of expertise and stick with that, and all good business people understand this. Neither people nor businesses are motivated to lend money when interest rates are high. They might be motivated to invest excess liquidity in an interest-based investment (CD's), but they will not (and should not) enter into an activity that they have no expertise in and that represents substantial risk (lending).

Oh, absolutely, they may use an intermediary lender or CD's or whatever. In that case they are effectively hiring (paying the interest rate difference) someone else to do the lending for them. That this occurs shows the benefits of the division of labor, as you point out. My point is that if, by doing that, they can gain a greater return on their capital investement (than investing in more trucks), then it would be in their best interest to do so, thus increasing the supply of lendable funds.

Just because an agency has the implicit backing of the gov't. doesn't make it OK for that agency to totally screw things up.

You are right, it doesn't. But here you are talking about the morality of it. I'm talking about the actual market forces and incentives. The implicit (and past and present explicit) government intervention is what distorted the market signals and incentives, causing this mess. You seem to be expecting people to act against market forces that push in an immoral direction (because government distorted these forces) out of their own virtue. Or if they don't then the government ought to regulate that behavior, to patch over the government's prior failings. This leads only to one intervention after another, needlessly taking away our liberty.

F&F doesn't guarantee mortgages;

That's not what I have heard. For example, "The FF guarantee that the principal and interest on the underlying loan will be paid back regardless of whether the borrower actually repays" (http://mises.org/story/3110). Or, "Fannie Mae puts a loan guarantee on the MBS, for which it earns a fee. Fannie Mae promises that in case there is a default on the MBS, Fannie Mae will pay the interest and principal "fully and in a timely fashion." The MBS, once it has Fannie Mae's guarantee on it, is sold to outside investors in denominations of $1,000 and up." (http://www.larouchepub.com/other/200...annie_mae.html).

Back to fractional-reserve banking: hopefully we've established that banks lend a portion of funds that they ACTUALLY TAKE IN.

Okay, fine. But they actually take in the same funds multiple times, and simultaneously have multiple demand accounts representing the same physical cash being taken in multiple times.

I am refering to the following:
The bank takes in actual physical cash from Alice.
The bank lends the actual physical cash to Bob.
Bob uses the actual cash to buy something from Charlie.
Charlie deposits the actual cash in his account.
In this example, Alice has not yet withdrawn her deposit. Thus the bank has taken in the same actual cash from Charlie that it originally recieved from Alice. Now two people (Charlie and Alice) have legal claims (demand deposits) to the same physical cash. That is why it is fraudulent.

The system allows easier, cheaper access to credit, safety of deposited funds, and the funds are guaranteed by the full faith of the U.S. government.

It is not clear that these benefits are worth the downside (negative side effects). And there are good reasons that the downsides are much, much worse--that is, that these benefits are only apparent.

[Denonymous]

I'll address a few of these:

That's not what I have heard. For example, "The FF guarantee that the principal and interest on the underlying loan will be paid back regardless of whether the borrower actually repays" (http://mises.org/story/3110). Or, "Fannie Mae puts a loan guarantee on the MBS, for which it earns a fee. Fannie Mae promises that in case there is a default on the MBS, Fannie Mae will pay the interest and principal "fully and in a timely fashion." The MBS, once it has Fannie Mae's guarantee on it, is sold to outside investors in denominations of $1,000 and up." (http://www.larouchepub.com/other/200...annie_mae.html).

This isn't entirely correct, but it doesn't hurt to think of that way. Fannie gives a performance guaranty on the underlying loans in a particular MBS. This basically means Fannie will repurchase the mortgage (pay all principal and interest) and pursue collection through a servicer. A "loan guarantee" is when a person or entity signs a Guaranty Agreement promising to repay a lender in the event of default. Our difference here is really just semantics largely due to my line of work, as most every loan I make is accompanied by Guaranty Agreements.

Okay, fine. But they actually take in the same funds multiple times, and simultaneously have multiple demand accounts representing the same physical cash being taken in multiple times.

I am refering to the following:
The bank takes in actual physical cash from Alice.
The bank lends the actual physical cash to Bob.
Bob uses the actual cash to buy something from Charlie.
Charlie deposits the actual cash in his account.
In this example, Alice has not yet withdrawn her deposit. Thus the bank has taken in the same actual cash from Charlie that it originally recieved from Alice. Now two people (Charlie and Alice) have legal claims (demand deposits) to the same physical cash. That is why it is fraudulent.

You're continuing to treat money as a finite commodity, instead of a medium of exchange. When Alice deposits $100, the physical bill isn't marked "Property of Alice" where no one else can ever spend it. It also makes no difference here whether Charlie deposits his funds in the bank or spends it at Wal-Mart. Money flows. It doesn't stay parked. If it did, nothing would ever happen in the economy.

Here's another take on your example: Alice owns a janitorial service. She earns $100 each night cleaning a local Wal-Mart (she obviously doesn't charge enough). The following day, she spends the $100 for groceries and additional cleaning supplies at Wal-Mart. That night, she again cleans Wal-Mart and is paid the same $100, and the cycle repeats itself. The "same" $100 has purchased multiple times it's value in goods, according to your scenario.

Oh, absolutely, they may use an intermediary lender or CD's or whatever. In that case they are effectively hiring (paying the interest rate difference) someone else to do the lending for them. That this occurs shows the benefits of the division of labor, as you point out. My point is that if, by doing that, they can gain a greater return on their capital investement (than investing in more trucks), then it would be in their best interest to do so, thus increasing the supply of lendable funds.

It may or may not be in their best interest to invest (or "lend" through the market) their funds, but THEY DON'T, so the supply of lendable funds does not increase. The people and entities that will invest in a CD when rates are high typically take that liquidity from other investment sources, where it was already a potential source of loans via the markets. Businesses use their excess funds to do more business in their chosen line of work. Also, in a high rate environment, businesses are likely to have LESS cash available for such things, as the cost of their operating debt will be increased. Lendable funds may increase in a high rate environment, but that's due to the lack of demand (or ability to repay at the high rates). A bank can't lower loan rates in order to balance supply and demand of the money in this case. The high rate environment forces them to pay higher rates on time deposits, higher rates to the Fed, causing a higher money cost with overhead that is relatively constant. There's very little room to lower rates so the laws of supply and demand can take over.

It is not clear to me how my assumptions are incorrect. I understand and agree everything you are saying here. What I'm talking about is what happens next, when you follow this example forward. So the bank has $100million in deposits (liabilities) and $100million in assets ($75 million in loans and $25million in cash). Now, those who borrowed the $75million will purchase things with it. Indeed, that is why they borrowed money. The sellers of the things purchased will then hold the $75million (say, in cash). They bring this $75million back to the bank to deposit into their own savings accounts. Now the bank has $175M in liabilities (deposits), and $175M in assets ($100M in cash, and $75M in loans). But, we have not introduced any new physical cash (there's only $100M in this example).

So already the effective money supply has increased, because the deposits ($175M) exceed the amount of physical cash ($100M). Please point out any mistake I am making thus far.

And this can continue even further, because the bank, at this point has a 100/175 = 57% reserve ratio, and can now make additional loans.

You're again making the assumption that all the money you have changing hands in this scenario stops being spent at some point and gets "parked" in the bank. Money MOVES. The $75 million above that made it's way to sellers will again be spent by those sellers on other goods. It won't be parked in the bank. A portion of it may be, but a portion of the other idle deposits will also be spent, keeping the deposit level relatively constant. A bank's deposits typically vary very little. Growth is obtained by attracting new customers (typically by branch expansion), not by somehow convincing all loan customers to deposit their proceeds in the bank. People don't borrow money with a given interest expense and then leave the money idle in a DDA that earns no interest.

Let's say you have a $20 bill. Take it out of your wallet. Maybe it was printed 10 years ago. That $20 has likely purchased $100,000 worth of goods and services over that time. Was additional money created???

Again, my explanations are grounded in practical banking experience, not economic theory. I'm certainly no economist. I think maybe you're taking the "money multiplier" exercises a bit too literally. The examples used to explain this effect don't occur (to the extent shown) in reality.

[joel]

You're continuing to treat money as a finite commodity, instead of a medium of exchange. When Alice deposits $100, the physical bill isn't marked "Property of Alice" where no one else can ever spend it. It also makes no difference here whether Charlie deposits his funds in the bank or spends it at Wal-Mart. Money flows. It doesn't stay parked. If it did, nothing would ever happen in the economy.

Here's another take on your example: Alice owns a janitorial service. She earns $100 each night cleaning a local Wal-Mart (she obviously doesn't charge enough). The following day, she spends the $100 for groceries and additional cleaning supplies at Wal-Mart. That night, she again cleans Wal-Mart and is paid the same $100, and the cycle repeats itself. The "same" $100 has purchased multiple times it's value in goods, according to your scenario.

A few points of clarification:
- The monetary base at any given point in time is finite. Also, at any given point in time, each unit of that monetary base is owned by someone (or a business). (Or at least this should be the case in a just and rational legal system.)
- Yes, of course, it is a medium of exchange and moves around.
- In what I have been saying, I am not assuming a demand deposit is a claim to a particular physical bill. I understand that money functions as a 'fungible good' and thus the claim is to a certain quantity of dollars, not particular physical bills. The point of the example is just easier to get across if you think of only one particular bill. But you still get the same effect when recognizing money as fungible.
- Also, I recognize that the supply of lendable funds is not limited by the money supply. Ultimately it is capital (goods, not money) that is being lent. Money is just the medium of indirect exchange (including lending), as you point out. This does not contradict what I am saying.

The example with Alice does not increase the effective money supply. The difference is that when Alice is paid her wage, she is taking in those funds in exchange for a service discharged. She gains an asset but not also a liability. The employer releases his claim on the $100 in exchange for the service. He then no longer has a claim to $100 (or, rather, has a claim to 100 fewer dollars than he did before). Then, when Alice spends the $100 in exchange for goods, she relinquishes her claim to them.

On the other hand, when I deposit $100 in the bank, then I still have a legal claim to $100. I have not relinquished my claim to $100, as in the case of paying wages or purchasing goods. If the bank lends it to someone else (or spends it at Wal-Mart), then they are transferring their claim to $100 cash to someone else, but I still have a claim to $100, thus the legal claims to dollars have increased beyond the quantity of actual dollars in existence. No longer can we say that each unit of the monetary base has a unique legal owner at any given point in time.

(Note, this need not assume claims to particular physical bills, but is true even with money's fungibility. It is provable mathematically simply by the pigeonhole principle (http://en.wikipedia.org/wiki/Pigeonhole_principle). I.e., if legal claims to dollars exceeds the quantity of actual dollars, then it is logically necessary that at least two people have (or believe they have) a claim to the same dollar, and thus some fraud has occurred. There is no logical necessity to be able to locate those specific people or physical dollars.)

A bank can't lower loan rates in order to balance supply and demand of the money in this case. The high rate environment forces them to pay higher rates on time deposits, higher rates to the Fed, causing a higher money cost with overhead that is relatively constant. There's very little room to lower rates so the laws of supply and demand can take over.

I think you are making a common mistake here. There is a tendency to think of costs being fixed. For example, suppose the demand for steel products drops. By a similar argument (to the one you are making) one could say that there is very little room to lower the price of steel products to balance supply and demand, especially in a 'high-steel-price environment.' Thus supply and demand cannot be balanced by means of the selling-price dropping. And thus one would conclude that this is a case in which the law of supply and demand fails, and the market fails.

The reason for this error is thinking that costs (in this example, the price of steel or its raw materials) are fixed, and that, therefore, costs determine the prices of end-products. On the contrary, costs are determined by end-product prices. If the demand for steel products drops, then the sellers will not be able to clear the market at the current price, so they will start trying to under-bid each other to gain market share and clear their inventory. So end-product prices will drop to balance supply and demand. In turn, this reduces demand for the raw material, because the producers of the steel products can no longer produce profitably at the same cost prices. This will drive down the prices of the raw materials. Thus costs are determined by selling prices. (In the same way, if demand for loans falls, then all the would-be lenders cannot clear the market at the going rates, so they will have incentive to under-cut each other to gain market share. They cannot continue offering high rates on their liabilities, thus the demand for them will, in turn, fall and those rates (that are bank costs) will fall.)

Actually, it is easier for me to think of the reverse case, of an increase in demand. This will push product prices up and create opportunity for profit, because the difference between the selling price and the costs has increased. As entrepreneurs work eagerly to capture this profit, they will begin to bid up their costs, until the opportunity for profit has vanished, because selling prices now equal the costs. In this sense all profits tend toward zero.

Well, this is true except for one thing. And I bring up this exception because it is related to what we are discussing regarding interest rates. An entrepreneur does not consider only whether the difference between the selling price and the cost is positive. If this difference is less than the market interest rate, then the entrepreneur will not invest his capital in the business project, and instead will seek the market rate of interest on his capital. Thus the difference between (actually ratio between) selling prices and costs tend not actually toward zero but toward the market rate of interest. Thus if the market rate of interest increases, fewer business opportunities will be reckoned as profitable, and capital that would have been used in those projects will instead be used to gain the market rate of interest (i.e., will be lent instead).

Another way interest rates affect the supply of lendable funds is in regards to consumption. When interest rates are higher, this will create an incentive for people in general to consume less and lend more at interest. When interest rates are lower (especially when less than the rate of inflation), people will tend to consume more now.

But of course, all of this is distorted when the Fed acts to manipulate interest rates, and I advocate abolishing the Fed and FDIC along with abolishing fractional reserve banking.

I think maybe you're taking the "money multiplier" exercises a bit too literally. The examples used to explain this effect don't occur (to the extent shown) in reality.

I've read quite a bit on this topic, and believe I am understanding it correctly. See, for example,
http://en.wikipedia.org/wiki/Money_creation
http://en.wikipedia.org/wiki/Fractional-reserve_banking

And one can easily demonstrate that it occurs in reality.
On Dec 1, 2008, the monetary base was $1.659 trillion (http://research.stlouisfed.org/fred2...GAMBNS?cid=124). This includes all bank reserves and Federal Reserve Notes held by the public outside of banks. This is all the actual money. If the public were to put banks out of business by withdrawing all the money from banks and ceasing to do business with banks, the public would hold a total of $1.659 trillion.

On the same date, the "M2 money supply" was $8.108 trillion (http://research.stlouisfed.org/fred2/series/M2SL?cid=29). This includes currency in circulation + checking account balances + traveler's checks + savings account balances + time deposits less than $100,000.

Thus people's claims to dollars exceeds the monetary base, by nearly a 5:1 ratio. By the pigeonhole principle, one can conclude that there is something fraudulent occurring. Normally this ratio is higher, but lately it is less because of the unprecedented skyrocketing of the monetary base--massive quantities of dollars being created by the Federal Reserve--in the past few months, as seen in the chart linked to above. For example, the same date a year prior the monetary base was $830 billion, and M2 was $7.404. This is a ratio closer to 9:1 which is more like what it has historically been.

Even M1 (which is currency outside of banks + checking account balances) has typically exceeded the monetary base (and thus claims to dollars exceeded the quantity of actual dollars) See http://research.stlouisfed.org/fred2/series/MULT?cid=25. Notice that only recently has the ratio dropped to 1:1 (and even slightly below in December), due to the Fed's recent unprecedented money pumping. Thus, right now, we could abolish fractional reserve banking on checking accounts, because banks are voluntarily holding reserves that cover them 100%.

[Denonymous]

A bank can't lower loan rates in order to balance supply and demand of the money in this case. The high rate environment forces them to pay higher rates on time deposits, higher rates to the Fed, causing a higher money cost with overhead that is relatively constant. There's very little room to lower rates so the laws of supply and demand can take over.

I think you are making a common mistake here. There is a tendency to think of costs being fixed. For example, suppose the demand for steel products drops. By a similar argument (to the one you are making) one could say that there is very little room to lower the price of steel products to balance supply and demand, especially in a 'high-steel-price environment.' Thus supply and demand cannot be balanced by means of the selling-price dropping. And thus one would conclude that this is a case in which the law of supply and demand fails, and the market fails.

The reason for this error is thinking that costs (in this example, the price of steel or its raw materials) are fixed, and that, therefore, costs determine the prices of end-products. On the contrary, costs are determined by end-product prices. If the demand for steel products drops, then the sellers will not be able to clear the market at the current price, so they will start trying to under-bid each other to gain market share and clear their inventory. So end-product prices will drop to balance supply and demand. In turn, this reduces demand for the raw material, because the producers of the steel products can no longer produce profitably at the same cost prices. This will drive down the prices of the raw materials. Thus costs are determined by selling prices. (In the same way, if demand for loans falls, then all the would-be lenders cannot clear the market at the going rates, so they will have incentive to under-cut each other to gain market share. They cannot continue offering high rates on their liabilities, thus the demand for them will, in turn, fall and those rates (that are bank costs) will fall.)

Your take on this is actually true in your scenario (deregulation, no Fed setting the rates, no minimum wage, etc.). Again, my points are from practical experience, not theory.

But of course, all of this is distorted when the Fed acts to manipulate interest rates, and I advocate abolishing the Fed and FDIC along with abolishing fractional reserve banking.

OK. Good luck with that! Let me know if you get a response when you write your congressman about it! (jk)

Seriously, this isn't going to happen, so you may as well concentrate on the situation at hand. Plus, fractional-reserve banking, government regulation, money creation, et al, didn't cause the problem we're stuck with now (though the Fed's rate policy had a huge unintended impact). Rampant greed did. And unfortunately, handing everything over to a "free market" isn't going to fix that. No market is free; the wealthy command the majority of resources and influence. Left to their own direction, the wealthy will band together to consoldate even more power and preserve their place at the top of the food chain. We have anti-trust and minimum wage laws for a reason.

I've enjoyed discussing this with you. Hope you got as much out of it as I have. Take care.

Denon

[joel]

Your take on this is actually true in your scenario (deregulation, no Fed setting the rates, no minimum wage, etc.). Again, my points are from practical experience, not theory.

Oh, I thought you were making an argument as to why 'my scenario' would not work. So I was explaining how it would. Otherwise, you seem to be arguing why the current government intervention makes things worse. In which case I agree with you.

OK. Good luck with that! Let me know if you get a response when you write your congressman about it! (jk)

Seriously, this isn't going to happen, so you may as well concentrate on the situation at hand.

All joking aside, I have written to my congressmen. I have participated in demonstrations, etc. If you would like I can send you the response I got from Dianne Feinstein, who 'recognizes the importance of' centrally managing the economy.

And you are right that it most likely won't happen. We abolished two other U.S. central banks in the past (the Federal Reserve is our 3rd central bank), but the Fed has been around long enough that people are used to it and most people don't know what it does. And fractional reserve banking is so ingrained in society that it would be difficult to convince enough people, besides the fact that people are short-sighted and want to protect their special interests (e.g., because of holding shares in banks).

So, yes, you are right that it probably won't happen. Most likely the government will do (as it has always done for the past 100 years) everything the exact opposite of what is needed to help the economy. It will prevent and delay liquidation of firms and business projects that are a drain upon the economy. It will inflate the money supply. It will try to control prices (including wages). It will try to encourage consumption and indebtedness and discourage saving. It will increase government spending, increasing its burden upon the economy. It will subsidize unemployment. It will let banks off the hook, enabling them to suspend fulfillment of their obligations while still demanding their debtors to fulfill obligations. It will hold interest rates out of equilibrium.

This is the situation at hand. The government will almost certainly make us worse off than we would otherwise be. Wouldn't it be wrong to refrain from at least trying to make things right, as opposed to sitting by? If enough people become aware, then we can make these changes. It is only because people lack the understand and the will that we are stuck.

Plus, fractional-reserve banking, government regulation, money creation, et al, didn't cause the problem we're stuck with now (though the Fed's rate policy had a huge unintended impact). Rampant greed did. And unfortunately, handing everything over to a "free market" isn't going to fix that. No market is free; the wealthy command the majority of resources and influence. Left to their own direction, the wealthy will band together to consoldate even more power and preserve their place at the top of the food chain. We have anti-trust and minimum wage laws for a reason.

And you say you were a supporter of free markets until just recently? Did you understand how free markets work before and you have recently found compelling arguments for these opposing claims you make? Because I have reason to believe the opposite of pretty much everything you said in this paragraph. Though I can't give a decent response to all your points in this post alone. I'll just give a synopsis.

I have reason to believe government intervention caused the problems we have. (And will continue to exacerbate them.)
As for 'rampant greed', you'll have to define that. And explain why self interest is necessarily a bad thing. Plus, this is insufficient as an economic argument. You'd have to explain why markets ever work and specifically how 'greed' would (or did) cause them to fail in particular circumstances.
It sounds like you have a Marxist view of markets in at least some respects. For example, it sounds like you view employment as some kind of slavery and exploitation, and have a dim view of the private ownership of capital goods. And you may be conflating economic power with political power.
Besides, your "no market is free" argument seems to be a matter of semantics. You need to respond to what I actually mean by "free market", and not merely to the word "free". If what I mean by free market does not seem to you to be 'free', then fine, ignore the word, and focus on what we mean. (We might use a different term, such as "unhampered market" instead.)

And I believe your understanding of consolidation/monopoly/cartels to be misguided. History has been the opposite process. Monopolies and cartels are very difficult and usually impossible to obtain or maintain in an unhampered market. The early 1900's for example are usually thought to be a time of growing monopolies and cartels and the government saved the day with anti-trust and regulation of big business. The opposite is more nearly true. Industry leaders found they could not maintain cartelization on the unhampered market and lobbied politicians to pass regulations that protected their cartels by force and hurt their competition. Most monopolies and cartels are created by the government by force. Government intervention has had the general effect of increasing rather than reducing consolidation of economic power. Much regulation of an industry is lobbied for by the industry leaders themselves.

I have come across numerous examples, including in my own experience. I grew up on a family farm where we had raised pigs. The large hog producers lobby for ever-increasing regulation of hog production which eventually pushed my family (along with most small farms) out of the business, leaving only the big corporations. They would not have acheived this elimination of their competition without the cooperation of government force.

This is true also in the case of banking. People often think that the Federal Reserve places restraint upon the banking industry. On the contrary, banks were unsuccessful in their cartelization attempts on their own in the market and so private bankers lobbied for the creation of the Fed which would use force to help them achieve what they could not achieve in the market alone.

And minimum wage? This comment makes me think that you either never actually were a supporter of free market or you never understood how markets work. In a beginning economics course one learns that price controls (such as minimum wage) are counterproductive--i.e., have the effect opposite that of the one for which they are proposed. For example, a price floor is usually proposed for the purpose of making the good more accessible, but its actual effect is to make the good less accessible. Minimum wage is proposed for the purpose of helping low-skilled workers and reducing inequality. Its actual effect is to perpetuate inequality and hurt (at least some of) these low-skilled workers. In fact, sometimes politicians have recognized this fact and used minimum wage purposefully as a tool for discrimination.

For example, I heard that in South Africa, where people with white skin were wealthy and people with dark skin were generally poorer and had less education, training, and experience, the white politicians passed minimum wage laws, not to help low-skilled workers but specifically for the purpose of barring them from the market--to 'protect' white jobs from competition. It was used as a tool for racial discrimination.

Minimum wage (and other labor laws) increases unemployment and allows employers to make hiring decisions based on their prejudices instead of based on what is economical. Both of these effects perpetuate inequality.

I've enjoyed discussing this with you. Hope you got as much out of it as I have. Take care.

I enjoy the discussion too. I hope we can continue. In your last post you did not respond to our main topic of discussion, which was the creation of money caused by fractional reserve banks, and the effects of that. Are we agreed now that it increases the effective money supply?

[Augustine2004]

Are we agreed now that it increases the effective money supply?

I think you mean the number of fiat dollars is larger than otherwise. Otherwise it's not clear what you mean, 'effective.'

[joel]

I think you mean the number of fiat dollars is larger than otherwise. Otherwise it's not clear what you mean, 'effective.'

That is a good question. It may just be that I don't know the right terminology and so my saying "effective money supply" could be said more precisely. If I remember right Mises used the terms "money supply in the narrow sense" and "money supply in the broader sense" to distinguish between two different concepts. The issue is clouded by a number of factors including to some legal fuzziness due to fractional reserve banking. And thus we speak of the monetary base and the M1 money supply and the M2 money supply, etc.

The point is that bank credit expansion does not create actual new dollars. It creates financial obligations that are treated as if they were actual new dollars, especially in the case of checking accounts where these financial obligations are traded from person to person as if they were actual dollars. Again in Mises' terminology, these financial obligations he called "fiduciary media," which he distinguished from money proper. Money proper plus fiduciary media add up to the money supply in the broader sense, and what I referred to as the effective money supply. Credit expansion creates new fiduciary media, but not more of money itself.

It is not effectively different than when banks used to print more bank notes (promises to pay gold) than there was gold. It was just more obvious then because it was easy for everyone to distinguish between an actual ounce of gold and a promise to pay gold. But with fiat dollars, there is no precise legal definition for "dollar", so we tend to speak of both money and fiduciary media as dollars, and it thus it becomes more difficult for the modern person to make the distinction between money and fiduciary media.

Suppose, for example, that gold ounces were money. And suppose that all Federal Reserve liabilities (e.g., Federal Reserve Notes) were backed 100% by gold reserves redeemable on demand. Then Federal Reserve liabilities would be proper money substitutes. It would then be more obvious that credit expansion does not expand the actual money supply, but only increases fiduciary media. But when this fiduciary media is treated as equivalent to money, then that causes the same effect as if the money supply (in the narrow sense) actually were greater. This is why I said "effective money supply."

This holds even when we remove the redeemability of Federal Reserve liabilities in gold. The (irredemable) FR Notes are legal tender, and are fiat money proper. The other FR liabilities (such as bank reserves held at the FR) are redeemable for FR Notes on demand and at face value, with 100% guaranteed backing (because the paper notes are printed up as needed), and thus are actual money substitutes.

Thus, in this thread I have been considering the FR liabilities (often referred to as the monetary base) as the money supply proper. These are the closest thing we have to 'actual dollars.' Credit expansion creates only the appearance of more fiat dollars existing (e.g., it does not create new paper FR Notes), but it produces the same effects as an increase in actual fiat dollars would.

Does this answer your question? Or do you think I should change my terminology? I suppose that it might depend on court interpretation. If the courts rule that this fiduciary media is legal tender equivalent to a paper FR Note, then the fiduciary media also is 'fiat dollars.' Again, this is up to interpretation because there is no longer any codified legal definition of "dollar."

[Augustine2004]

A reason the money supply contracted in the Great Depression is that every time a bank fails, it ceases to be part of the fractional reserve system. It diminishes by that much. 6,000 banks failed in the depression.