Fractional Reserve Banking from a Modern Finance Perspective
By Arnold Kling
Walter Block, arguing against Bryan, says that fractional reserve banking is fraudulent. There is some chance that when you make your deposit you will not get your money back, and instead someone else will have taken title to it. Therefore, your rights were violated.
My point will be that there are many other modern financial contracts with the feature that there are contingencies where the contract cannot be fulfilled.
[UPDATE: a commenter points to a post by Eric Posner that makes my point more clearly.]For example, I think that it is fair to say that my reading of AIG is that if there are enough defaults on bonds that they insured, they will not be able to meet all of their obligations under the credit default swaps that they sold. However, my reading is that at least one person, Gary Gorton, believes that AIG will not suffer so many losses on their default swaps, and if their counterparties would just be patient things would be fine. It sounds to me as though AIG put itself in a position similar to that of a fractional reserve bank. Under some conditions, it cannot fulfill its contracts. Because of that, a “run” took place at AIG.
Other modern financial contracts that cannot necessarily be fulfilled: any deep, out-of-the-money unhedged short option position–credit defaults swaps being just one example; any short sale, because the price can rise so fast that the short seller is busted before he can buy out his position.
Defined-benefit pension plans are probably fraudulent by the strict definition. Surely, there are contingencies where the pension plans will not be able to meet their obligations.
From an individual point of view, you get some protection from risk by diversification. Otherwise, in the modern theory of finance, there is room for a risk-free asset. What Block and others want to call fraud is the pretense that bank deposits are a risk-free asset. But people incur all sorts of other risks in the modern financial sector that they tend to ignore. They think that there are lot more risk-free assets out there than is the case.
My view of the world is that people’s trust that assets are risk-free is a beautiful but dangerous thing. Right now, most of that trust is being placed in the securities of the U.S. government, which in turn is guaranteeing everything in sight, which by all logic should completely undermine that trust. I keep wondering what the new safe haven will be when people start to treat the U.S. like the banana republic it is becoming.