Tangentially related to this recent thread on “fiat money” vs. the gold standard. I’ve been following a thread another board where several posters are arguing that fractional-reserve banking is somehow fundamentally dishonest, and inflationary, and a “Ponzi scheme” doomed to collapse, because it enables bankers to make money out of nothing. “Where does the interest come from?” Authorities cited include [by [url=Murray Rothbard - Wikipedia]Murray Rothbard,](]The Mystery of Banking,[/url) and Tragedy and Hope, by Carroll Quigley.
Is there anything to this? It seems to me the banking-skeptics are thinking like the medieval Thomist Scholastics who followed Aristotle in holding interest on loans is “unnatural” because gold is a lifeless, inert substance and as such does not grow; which is why the Church banned “usury” (defined as charging any interest on a loan), and retarded Europe’s economic development for centuries. Does anybody seriously believe that industrial capitalism, or commercial capitalism, or any economic activity beyond the level of feudal agrarianism would be possible without fractional-reserve banking? As for its being “doomed to collapse,” fractional-reserve banking has been thriving at least since the 17th Century (perhaps longer – by some theories the Knights Templar invented it), throughout the rise and fall of European colonial imperialism, several world wars, global depressions, revolutionary threats to capitalism as such, and singularity-grade sociocultural changes. If it is doomed to collapse, it certainly seems to be taking its own sweet time doing it. What is there, really, to be said against it?
Bankers don’t make money out of nothing. When they lend money out, it is typically used to create something of value - a house, education, a business, whatever. The interest is paid from the value that was created.
But it does come from nothing, doesn’t it? Hopefully it ends up being tied to something with actual value like you describe here, but sometimes it doesn’t. And then we find out about it later, and that’s how bubbles happen.
bubbles happen when people act irrationally. every bubble from the tulip bubble of the 1600s to the recent housing bubble, the people doing the trading KNOW they’re doing something wrong but the allure of a payday right then and there was too much to resist. nobody expects a tulip to be worth a chest full of gold just the same way that nobody expects a single young mother can afford a quarter-million dollar house. however right then, someone else is willing to give you a chest of gold for your tulip bulb, or your right to mortgage payments from a woman who’s not going to pay her mortgage, are you going to say no?
the fractional reserve system had nothing to do with it.
and as for $ coming from nothing, it’s not nothing. it’s the future worth of something - a concept that’s very real in economics (and real life too).
There’s a video which explains the case against fractional reserve banking. Its 45 mins and seems to present a good case. Its basic premise is that money used to represent value, and now represents debt. This debt is ever-increasing and can never be paid off. Every time a loan is repaid, more money is required than was included in the loan originally (due to interest).
Since pretty much all money is created from loans, which all have to be repaid, a certain number of people will necessarily default, unless the money supply keeps increasing. Crashes occur when the money supply stops increasing (ie banks stop giving out new loans). At this point there is insufficient money in the economy to pay off all the current loans, so inevitably some people can’t.
The film uses the analogy of a game of musical chairs, everything is ok until the music stops playing, but then when everyone tries to sit at once, not everyone can find a seat. At this point the banks step in and start repossesing homes, cars, and other material, tangible wealth.
However, there is no doubt that the system is good for fast economic growth. It is certainly not sustainable though, not without constant bubbles and crashes.
To paraphrase Churchill, fractional reserve banking is the worst monetary system ever devised except all those other forms that have been tried from time to time.
You know, that video would be accurate, if it wasn’t possible to add value to things, as well as debt. If it wasn’t possible to add value, then we’d never be able to get out of debt. But since a field of grain is worth more than some dirt and some seeds, it is possible to add value to things. Thus, debt can be canceled out.
That’s pretty trivial economics. Even simpler than utility and marginal utility.
And free to download, I might add. What a delight. You should also check out his “America’s Great Depression” which is also free.
To me the fundamental, bedrock layman’s explanation of why fractional-reserve banking is a fraud (to paraphrase Rothbard) and cannot work is because two parties are simultaneously claiming the same asset.
The government allows this, and even guarantees it with yours and my money, in the case of FDIC insurance on deposits.
Venture capital funds, for example, take money from investors and then lock it up while it is being invested. It cannot be returned to the original investor at the same time it is being invested in the companies within the portfolio. And if the investments go bad the investor loses his money.
Bank deposits, on the other hand, are loaned out whilst they are simultaneously allowed to be claimed at any time by the depositors. And the depositors’ funds are even guaranteed by the government (meaning: you and me) to boot.
That is a fundamental fraud - allowed by, regulated by, and even sanctioned by the government. The government outlaws it in every other industry except for banking. Rothbard has some examples in his book of where other industries such as grain elevator companies have tried this, and have had the practice struck down by the courts.
Good reading. Especially the next time you’re in a debate with someone who claims the ‘free market’ is what caused the recent financial crisis. Hmph!
Which is why interest is charged. If you know that a loan of a certain type will make something of twice its value 90% of the time or completely fail the other 10% of the time, you can charge enough to cover the 10% and it can be paid back because something of twice the value of the loan is more than enough to pay off the loan plus the interest.
Claim that it’s fraud: The bank and the customer both know what happens with the cusotmer’s money, there is no deception about where the money goes, and so the claim of "fraud’ relies on saying such an arrangement can’t possibly exist, which is bull.
I know my bank is lending out some of the money in my bank account. That’s why they don’t charge me for having an account. If I had a safe-deposit box for keeping money, they’d charge me for the privilege, because it costs the bank money to have a vault, and because they can’t earn interest by lending out the money I keep in the box.
To claim fractional reserve banking is fraud, you have to (and some of its crazy opponents, such as Rothbard, do) argue that it’s fraud even though I and the bank both know what happens to the money in my account, and even though I and the bank are just fine with that. Such an argument simply makes no sense.
Claim that it inevitably fails: already addressed–only true if value can’t be created other ways. Let me address this one by responding to a question from the thread.
The question is: If I lend you $x, and want to get back $X plus interest of $Y, where does the value for $Y come from?
Well, there are lots of ways for a house to gain value–but why limit to not spending more money on it?
The biggest source of new value from my house is that I live in it, and so can look professional, have a home address, and generally not be a hobo, and so can do my job, and earn money by using my skills to create value.
And that is the best response to your question. Where does the new value come from to pay back my mortgage? It comes from my job, not from my house. I also use my salary to invest in my house, to improve it–but the point is I can pay back my mortgage, plus interest, even if my house doesn’t gain a dollar in value. Why? Because it permits me to earn money.
My best analogy is that I borrow $10 from you, promising to pay you back $11, and use it to buy ten chocolate bars. I then eat the chocolate bars. Have I defrauded you?
Only if I can’t pay you back. But in that example, it’s obvious that I’m not aiming to pay you back by the chocolate bars gaining in value. I’m only defrauding you if I don’t have another source of income.
Claim (as seen in the “money as debt” video cited earlier) that it is inherently fraud because banks lend out more money than they have: [MORBO] FRACTIONAL RESERVE BANKING DOES NOT WORK THAT WAY [/MORBO].
There are many reasons why this is wrong. The argument is that #1–the person the bank lends money to, “borrower,” and #2–the person depositing money at the bank, “depositor” each have a claim on the same dollars.
Now, first of all, you have to get past the hurdle that most depositors, if you ask them, understand completely that the bank lends out some of its deposits, but keeps enough money to cover withdrawals as needed. So you have to claim a system is fraud even though both Bank, Borrower, and Depositor know what’s going on. That is hard.
But more importantly, if I deposit money with a bank, I am not claiming the asset. I have a right to claim it on demand. Those are very different. If I tried to withdraw money from my account, and the bank said “no, it’s lent to borrower”–THEN two people would claim the same asset. But if the ATM gives me dollar bills on demand, then I have just successfully claimed my asset.
Simple version: Grain elevators are not banks.
More complex: This is one of Rothbard’s funniest arguments. As you and I discussed in a previous thread, his argument that grain elevators couldn’t do this was based on the fact that the government declared it to be fraud.
So the argument is: Government says X is fraud. X is like Y. So Y is fraud. Except the government says Y is not fraud. So the argument is based on the government’s definition of fraud in the context of grain elevators, and is being used to override the government’s definition that fractional reserve banking is not fraud.
ETA: here is my response from the prior thread. It speaks for itself. The thread itself is useful to read. N.B. DDA’s=what IdahoMauleMan is talking about when he’s talking about grain elevators.
Plus there is a time value of money. $50k is worth more for you to have in your pocket today than 10 years from now because you are able to use that money to create better and more valuable things
Please don’t insult me. I know exactly how to read a bank’s balance sheet. I am trying to explain this to the layman. You are throwing around technical accounting terms which, while correct, are not adding anything to the discussion.
The deposit is a liability to the bank. It is an asset to the depositor, who has a legal claim to it.
If the money is loaned out to a business it becomes an asset for the bank on the bank’s balance sheet. That business could then use that money to build widgets, sell them to a customer and create a receiveable which would create another asset on the balance sheet of the business. It would become a liability to that business’s customer. And so on.
But if the customer of the business cannot repay that asset of the business, or the business squanders that money and cannot repay it back to the bank, the depositor still has legal claim to that money, backed by the government (meaning: you and me).
That was my original point. The depositor still has legal claim to that asset (of his), even though the money is gone.
I apologize if you felt insulted. That was not my intention.
You are correct in that the original depositor and the business which has taken the loan can both claim that money as their own asset. But in reality, this is meaningless because the system is based on the predictibility of depositors. Tomorrow morning, not everyone will go to the bank and withdraw all of their money. Only some will. We know this and history has proven it.
Since this is the case, there is no need to let this money remain idle. Let others use it to be productive, pay the depositor interest for the use of the money, and all are happy.
If your argument was that the system WOULD collapse if both parties tried to claim and use the asset at the same time, then you are correct. But they don’t and won’t.