Yesterday at the FEE seminar, I got to hear the excellent Jeff Hummel thoroughly debunk the crazy Rothbardian view that fractional reserve banking is “fraudulent.” It was a fun (and funny) lecture, but the target was too easy. So during the Q&A period, I decided to see whether Hummel would embrace a far greater heresy. My challenge for him:
Agree or disagree: In developed countries during the last 10-15 years, central banks have become (close to) the most efficient state enterprise.
To put the question a little differently, imagine comparing the performance of actual state enterprises to the performance libertarians believe the unregulated market would deliver. In Western countries, would the gap between the status quo and Libertopia be one of the smallest?
What do you think? I’ll give Jeff’s answer – and mine – next week.
READER COMMENTS
MattY
Jul 18 2008 at 10:50am
I generally believed that a socialized retirement bond system had the best shot at maintaining some efficiency. But, now that I think it through, the Fed is not too bad, though still way below libertarian efficiencies.
However, I still maintain my recent discovery, earmarks are the most efficient thing that Congress does. Earmarks are the natural socialist enterprise. Seriously. If congress was designed to do anything at all, then it is earmarks and district projects. I have come to the conclusion that we want congress to do more of them and less of all the other stuff.
Horatio
Jul 18 2008 at 11:15am
I think the military is the most efficient state enterprise. Government certainly demands more war than the market would, but if the market demanded just as much, the military would be much the same. The military has been the one state enterprise that has never been sheltered from competition. In fact, the stakes and level of competition the military faces are far greater than we ever find in the free market.
John
Jul 18 2008 at 11:41am
The latest edition of Economic Affairs has an excellent short article by Tim Congdon titled ‘Should the Bank of England exist?’ that critiques the role of the UK central bank in the credit crunch and in particular its role in relation to the near collapse of Northern Rock (sic) bank. I’m afraid I don’t have an ungated link but those of you with university library access should be able to read it via Wiley-Blackwells.
zanon
Jul 18 2008 at 11:43am
I’d love to hear Hummel’s debunking of fractional reserve banking.
Is there a link?
Also, saying central banks are the most efficient state owned enterprise is setting the bar low.
-zanon
Scott Wentland
Jul 18 2008 at 3:06pm
The gap between public and private universities is pretty small (excluding some outliers). Albeit, neither seem very efficient in some absolute sense.
Al
Jul 18 2008 at 4:53pm
I’d also like to hear Hummel’s debunking of Rothbard’s silly stance on fractional reserve banking. Rothbard has always been a subpar economist, IMO.
Adam
Jul 18 2008 at 4:55pm
That’s like asking if grasshoppers taste better than tree bark. While it may be true, it doesn’t really mean that much in a larger context.
Libra
Jul 18 2008 at 6:01pm
I’ll third the request for Hummel’s remarks.
It’s hard to believe that you consider full reserve banking crazy when the government is in the middle of transferring hundreds of billions of dollars to banks who traded in maturity mismatched securities. If any other business in the world had an over leveraged credit structure blow up like that, we’d let them go bankrupt to teach a lesson to the world to maintain sound financial practices. Yet somehow, advocating that banks should not make massively over-leveraged loans is crazy talk. I am miffed.
megapolisomancy
Jul 18 2008 at 6:01pm
The title of his talk was “Why Fractional Reserve is More Libertarian than the Gold Standard”.
Fractional reserve banking and a commodity based currency are not mutually exclusive. I am curious why Jeff Hummel believes that fractional reserve banking should exclude the gold standard.
Brian N.
Jul 19 2008 at 6:05pm
Given that a demand deposit in a bank is an agreement to redeem money stored on demand (hence the name) storing only a part of the money and then lending the rest to other parties is in fact an act of fraud. The problem in various strident dismissals of Rothbard’s position is a blatant ethical screw-up that doesn’t understand an important fact; the money is still the depositor’s, when in the bank. A banker doesn’t come to own the depositor’s money by virtue of the deposit agreement, unless it specifically is so stated. I don’t know why banks are, as Rothbard observed forty-five years ago, treated with such a special deference? Why is it that they’re allowed to do what would, in any other line of business, be an act of fraud? Then, Beck’s maxim, validated more than once here, comes to mind.
“It’s because economics, as generally practiced today, hasn’t a moral bone in its body, and that makes it just about completely worthless, at best.” –The Abysmal Science
Viktor Zhumatiy
Jul 20 2008 at 12:24am
Would you please recommend a published critics of the Rothbardian view? I went through the reference, and did not find anything crazy. So it is interesting for me to read a sound critical analysis.
Adam
Jul 20 2008 at 4:06am
It’s not an act of fraud if this information is disclosed to the depositors. If the depositor is aware, then it’s not “criminal deception.” As practised today, it does have an air of fraud since the information is generally glossed over. But it is certainly available to even a casual observer, particularly to anyone who’s seen It’s a Wonderful Life.
Putting money in the bank and expecting interest in return is, by definition, an investment. All investments entail risk, and this is the risk. More transparency about the process is all that is needed, not an abolishment of the practise.
Brian N.
Jul 20 2008 at 8:19am
Adam, at that point we’re not even talking about a demand deposit anymore. What we’re really talking about is a loan to the bank, or an investment in its lending apparatus, for which the lender is paid a percentage.
“But it is certainly available to even a casual observer, particularly to anyone who’s seen It’s a Wonderful Life.”
So I can know, with certainty, what practices my bank engages in by watching an antiquated Jimmy Stewart movie? That’s an utterly insane thing to say.
Besides which, Rothbard (and the movie, implicitly) dealt with fractional reserve banking as it was actually practiced, not as it might be practiced. Bankers had been lending out depositors’ money (depending on the number of depositors, a potentially severe form of inflation) without the depositors’ knowledge. This was fraudulent. If the practice were out in the open, it would be called by its proper name; a loan.
Adam
Jul 20 2008 at 6:16pm
Brian,
An account is a contract with the bank. What does the contract say? That’s the final arbiter of whether this is fraud. My account paperwork contained the clause that my money is only available for withdrawal as long as there are sufficient funds available to cover it, otherwise my account becomes a timed account. I would hazard a guess that most, if not all, banks have these types of clauses in their contracts. I’m sure that this wasn’t always done in the past, so that would have been fraud, sure.
Fractional reserve cannot, in itself, be fraud. Fraud can only exist at the transaction level. Was your transaction with your bank fraudulent? That would depend entirely on the contract you signed. If your contract guarantees 100% redeem-ability at any time, then yes, fractional reserve would be fraud. Of course then you couldn’t earn any interest, but that’s between you and your bank.
Calvin Kostov
Jul 22 2008 at 5:19am
My bank says that when I put money in my account it is a ‘deposit’. But this is not the case as it is more akin to a loan, the bank comes to own my money and the only way I can get it back is to call in the ‘loan’ or withdrawal funds. I would call this fraud, no matter the economic jumping needed to call it a ‘contractual arrangement’.
Nascent Grasp
Jul 23 2008 at 12:22am
If I intend to withdraw all my savings from a bank and find out I can not do so today how should I react to my disappointment? Perhaps I should have paid more attention to the terms, in which case I would have expected a higher return or considered keeping gold in a hole in the ground.
Dsylexic
Aug 8 2008 at 7:41am
Ponzi schemes under contract arent fraudulent as well,then?.
Fractional banking is a sophisticated ponzi scheme.
Its tempting ,yet ‘risky’ .Calling it ‘risk’ enhances its respectability amongst the academics.
Bill Woolsey
Aug 8 2008 at 5:30pm
The notion that the word “deposit” means “promise to store” is incredible. However, if that were to become the legal meaning of the word, then banking would simply need to develop a new term to describe a loan made to a bank with a promise to repay on demand.
Banks do not promise to store deposited funds. They are very open that their business is to take deposited funds and lend them out.
Anyone who believes that banks are storing their funds for free, much less paying them to store their funds, would be an idiot.
If banks were charging people to hold deposits, then, perhaps someone might plausibly claim that they thought that they were paying for storage, but that isn’t the reality. People earn interest on deposits.
A substantial portion of bank deposits are time deposits. While they are generally payable on demand, early withdrawal involves the sacrifice of interest.
If someone promises to pay on demand, and someone demands payment, and the funds aren’t there, that isn’t fraud.
For example, suppose someone promises to pay in six months. The funds might not be there in six months, but that doesn’t mean there is a fraud. Many things could happen that result in the funds not being available (like business losses.)
It is, of course, correct that a bank doesn’t gain “ownership” of funds that are deposited. The bank is borrowing the funds and must repay them. If the bank “owned” the deposited funds, then they could simply pay them out to the stockholders.
Fractional reserve banking is not a ponzi scheme. It does not involve paying high returns on the first deposits with funds raised from later deposits. It doesn’t require an ever growing amount of deposits to continue.
A bank can issue $100k in deposits, loan out 90k, earn interest on that 90k and use part of that money to pay interest on the $100k of deposits.
Suppose one attempted to ban fractional reserve banking. Suppose that lending is then handled by bbanks. These institutions borrow small amounts of money for one year and then lend it out for a year in larger amounts.
Such institutions might fail. For example, if the bbank’s enough of the bank’s creditors fail, then it couldn’t pay off its debtors. That isn’t fraud.
Now, suppose that the bbank borrows for six months and makes loans for a year. After six months, the instituion can attempt to get those lending to it to lend for another six months, find others to lend for six months, or sell of the loans that will be coming due in six months. These are all reasonable plans. There is nothing fraudulent about this. But, it may not work out. That is, those currently lending to the bank may not renew loans, new lenders may not be forthcoming, and the loans made by the bbanks may not be sold for enough money to pay off the loans coming.
Now, why can’t the bank borrow for one month? One week? One day? One hour? One second?
One day is an interesting term. Someone goes to the bank and lend the bank money. The bank promises to pay the money back in one day, but only upon request. The bank will assume that the person lending it money will roll over the loans until notified. From the next day on, the individual can collect the money upon request.
The bank is borrowing for one day. These are time deposits. And then, they take the funds and lend them for one year (or 30 days, or six months.)
The notion that reading into “payable on demand” anything would restrict the banking industry is absurd.
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