HB's Four Economic Environments

[moda0306]

AgAu,

Wait, the bank has the money... they're loaning it out to someone when someone else "thinks" it's a deposit in their bank...  Maybe the checking account holder doesn't really have a deposit to pull out, but if I go to the bank and they borrow me $4k to buy a used car, that money is transferred to the bank of the guy who I buy the car from.

Am I missing something here?

[AgAuMoney]

AgAu,

Wait, the bank has the money... they're loaning it out to someone when someone else "thinks" it's a deposit in their bank...  Maybe the checking account holder doesn't really have a deposit to pull out, but if I go to the bank and they borrow me $4k to buy a used car, that money is transferred to the bank of the guy who I buy the car from.

Am I missing something here?

Very much so.

If the reserve requirement is 100% it can only happen once.  But that is not the case in fractional reserve banking.

In short, by loaning money the bank adds to its reserves so more money can be loaned.  This process repeats over and over again.  It doesn't matter if you deposit your loan in a different bank, reserves are cumulative and money creation is cumulative thruout the banking system.  The money created is a multiple of the money deposited.

The multiplier is 1/R where R is the reserve requirement as a fraction.  If the reserve requirement is 10%  then R=1/10.  m= 1/(1/10) = 10.  In other words, with a 10% reserve, 10x the money can be created.  Or a $1000 deposit becomes loans of $10,000.  With a 20% (or 1/5) reserve it is only a 5x multiplier.  A 100% or 1/1 reserve is a 1x multiplier.

http://en.wikipedia.org/wiki/Fractional ... iplication

Edit:
http://ecfr.gpoaccess.gov/cgi/t/text/te ... .4&idno=12

Shows current reserve requirements.  Wonder if that link will work?

In short, worst case for checking (transaction) account deposits is 10%.  Smaller banks must hold 3% or tiny banks have no reserve requirement.  (bigger the bank, the more protection is needed to forestall a 'run'.)

The reserve requirement for all other types of accounts (savings accounts, CDs, etc) is 0%.  That makes the multiplier infinity.

Edit:  Here's Murray Rothbard's take on it:  http://www.lewrockwell.com/rothbard/frb.html

[Tortoise]

A bank creates money by loaning money it does not have.  That is fraud.

So simple, and so true.

See the second item in the "See Also" section at the bottom of the Wikipedia article on embezzlement:

http://en.wikipedia.org/wiki/Embezzlement

[Lone Wolf]

The same is true when a bank loans money it does not have.  A bank creates money by loaning money it does not have.  That is fraud.

I have to agree.

If a saver directly lends out $1,000, they are foregoing $1,000 worth of consumption.  The borrower then uses this saved $1,000 of resources to make some sort of business or capital investment that (hopefully) creates some greater value later.

The role of a bank here is to allow savers to pool their money together and essentially act as a "matchmaking service" between borrowers and lenders.  In a full-reserve banking system, this is where it ends.

Fractional reserve banking is akin to the saver lending out $10,000 but only foregoing $1,000 worth of consumption.  We now have an additional $9,000 competing over the same scarce pool of resources.

Furthermore, the only way to keep this practice stable is to heavily subsidize it with instruments like the FDIC and central banking.  How much would it cost to obtain private insurance equivalent to what the FDIC offers to backstop the hazards of fractional reserve banking?  Much, much more than banks currently pay, that's for sure.  That means that FDIC insurance is a grand subsidy program.

[MediumTex]

It seems to me that fractional reserve lending can work fine if the reserve requirements are high.  Perhaps something like 80%. 

I understand that there is still an element of fraud in such an approach, but I think it would be relatively resilient (though the bankers would, of course, hate it).

[moda0306]

So does that mean that the bankers are collecting 6-10% interest on $10,000 when they are only paying .01% interest on $1,000 of deposits?

If so, Viva La Revolucion!

[MediumTex]

So does that mean that the bankers are collecting 6-10% interest on $10,000 when they are only paying .01% interest on $1,000 of deposits?

If so, Viva La Revolucion!

Plus late fees, origination fees, and whatever other fees they can think up.

It all works fine until the value of the underlying collateral begins to deteriorate.  When that happens, look out!

[moda0306]

I've long avoided getting truly angry and anarchic towards banks... until now... I need to read up.

I have to think there's some clarifying retort out there that will reasonably defend fractional reserve banking.

[MediumTex]

I've long avoided getting truly angry and anarchic towards banks... until now... I need to read up.

I have to think there's some clarifying retort out there that will reasonably defend fractional reserve banking.

The best defense is probably that during times of prosperity fractional reserve lending can really juice an already-healthy economy.

Of course, as von Mises noted, what I am actually describing is the massive misallocation of capital that sets the stage for the bust that follows a credit-fueled boom.

So maybe fractional reserve lending is sort of like the cigarettes that help to enhance a beer buzz--you are still going to be hung over if you overdo it, but the cigarettes may also kill you completely apart from the effects of the alcohol.

[moda0306]

If the U.S. and Japan are so similar in terms of type of currency and demographics (comparing Japan of the past to U.S. today), as well as having gone deep into (public sector) debt at one point or another (200% debt/gdp for Japan... currently about 90% for US I think).

What about Japan's strategy with it's currency resulted in its people NOT leveraging into a ton of debt (its government did, but not the private sector).

I often think there's way too much equating of public sector debt and private sector debt (like the modern monetarists), but can't deny there's a huge private-sector debt problem that seems to have been aided immensely by the federal reserve.

What the heck did Japan do differently to avoid such debt amongst its people?

[MediumTex]

What the heck did Japan do differently to avoid such debt amongst its people?

If you look at the prices Japanese people were paying for real estate near its peak and the 100 year mortgages they were in some cases taking on, I would say they probably did the same thing we did in the early to mid-2000s with housing debt.

[moda0306]

MT,

That may be so... but while I have no real numbers to back it up, I was under the impression that the Japanese have historically had very solid balance sheets.

I wonder what kind of down payments and mortgage durations they were taking on at the height of the boom.

[Tortoise]

Furthermore, the only way to keep this practice stable is to heavily subsidize it with instruments like the FDIC and central banking.  How much would it cost to obtain private insurance equivalent to what the FDIC offers to backstop the hazards of fractional reserve banking?  Much, much more than banks currently pay, that's for sure.  That means that FDIC insurance is a grand subsidy program.

Absolutely. If the banks used free market insurance on their deposits rather than FDIC "insurance," the premiums would indeed be higher since the risk of bank insolvency is higher than the cost of FDIC "insurance" implies. I suspect the cost of private insurance premiums on bank deposits would actually be higher than the interest paid out on those deposits. In other words, on balance, the bank's customers would be paying a fee to have the safety of their bank deposits guaranteed.

In terms of the costs and net result, that would simply be equivalent to 100% reserve banking: paying a fee to deposit your money safely at a bank, knowing that it is guaranteed to be there on demand, at any time you choose.

[6 Iron]

I am in strong agreement that reserve requirements are too low. But how would drastically raising them, e.g. 80 %, not have a profoundly negative impact on access to capital and economic growth? If there were not a fractional reserve system at all, wouldn't banks be restricted to loaning money from fees and initial investment capital in the banks, since all deposits have to be held in reserve for their depositors? I may be oversimplifying, but I cannot help but think of Jimmy Stewart's speech during the run on the Bailey Building and Loan.

[MediumTex]

I am in strong agreement that reserve requirements are too low. But how would drastically raising them, e.g. 80 %, not have a profoundly negative impact on access to capital and economic growth? If there were not a fractional reserve system at all, wouldn't banks be restricted to loaning money from fees and initial investment capital in the banks, since all deposits have to be held in reserve for their depositors? I may be oversimplifying, but I cannot help but think of Jimmy Stewart's speech during the run on the Bailey Building and Loan.

80% may not be the right number, but there probably is some reserve number that would allow for economic growth in the current economic system while also providing adequate cushion in the event of massive defaults.

I just think that way of thinking is utterly foreign to today's bankers who only know leverage and assume the private profits/socialized losses model will always be around to take care of them when things go haywire.

[Tortoise]

If there were not a fractional reserve system at all, wouldn't banks be restricted to loaning money from fees and initial investment capital in the banks, since all deposits have to be held in reserve for their depositors?

No, because of the difference between time deposits (e.g., CDs) and demand deposits (e.g., checking accounts):

http://en.wikipedia.org/wiki/Time_deposit
http://en.wikipedia.org/wiki/Demand_deposit

To avoid fraud, a bank would not be allowed to lend out its demand deposits, but it would be allowed to lend out its time deposits. With time deposits, the bank explicitly states that the deposit will be unavailable for a specified period of time (unless the customer pays a penalty), so in that case it is not fraudulent for the bank to lend the money--provided it limits itself to lending out 100% of the time deposit or less, as opposed to creating money out of thin air by lending out more than the time deposit.

[6 Iron]

To avoid fraud, a bank would not be allowed to lend out its demand deposits, but it would be allowed to lend out its time deposits. With time deposits, the bank explicitly states that the deposit will be unavailable for a specified period of time (unless the customer pays a penalty), so in that case it is not fraudulent for the bank to lend the money--provided it limits itself to lending out 100% of the time deposit or less, as opposed to creating money out of thin air by lending out more than the time deposit.

But then, wouldn't the bank be limited to loaning out money from a 6 month CD for less than 6 months?

[Tortoise]

To avoid fraud, a bank would not be allowed to lend out its demand deposits, but it would be allowed to lend out its time deposits. With time deposits, the bank explicitly states that the deposit will be unavailable for a specified period of time (unless the customer pays a penalty), so in that case it is not fraudulent for the bank to lend the money--provided it limits itself to lending out 100% of the time deposit or less, as opposed to creating money out of thin air by lending out more than the time deposit.

But then, wouldn't the bank be limited to loaning out money from a 6 month CD for less than 6 months?

That would certainly be the most prudent approach for the bank. But borrowing short and lending long (called loan maturity mismatching) is an option that is deemed by some economists and libertarian scholars to be merely risky, not fraudulent. There are academic debates surrounding this issue, for example:

http://blog.mises.org/11398/the-legitim ... ett-block/
http://blog.mises.org/11369/free-bankin ... smatching/

If most banks were to match their loan/time deposit maturities and hold 100% reserves for demand deposits, at least one Austrian economics scholar (Guido Hülsmann) claims that roughly the same level of financing would remain available, but that it would likely shift away from debt financing into the form of equity financing.

One possible example: For loans that are longer-term than most time deposits (such as 30-year mortgages), banks could make the loans using capital raised in the stock market. If they loan wisely, the stockholders will be rewarded and in turn the demand for the bank's stock will rise. If they loan foolishly, the stockholders will get burned and in turn the demand for the bank's stock will fall.

[AgAuMoney]

I've long avoided getting truly angry and anarchic towards banks... until now... I need to read up.

I have to think there's some clarifying retort out there that will reasonably defend fractional reserve banking.

The only one I've heard...

"I own a bank."

(I don't, btw.)

[stone]

I find the late 19th century early 20th century prosperity despite falling prices fascinating. I guess the deep trend for stock prices is tracking the median wage. That was increasing then and supply grew to keep up with it so preventing inflation. People talk about demographics of people of investing age governing stock price trends but deep down it takes a customer base able to pay for the products the companies sell. The developed world has had no real inflation adjusted increases in median wage for 30 years and so increases in stock prices since then look perilously like reversable froth. That period 100 years ago had an emerging class of consumers who provided the customers supporting stock prices. Do we now have little scope for increasing prosperity in the developed world? Are emerging market consumers the new hope?

[AdamA]

I find the late 19th century early 20th century prosperity despite falling prices fascinating.

Some argue that it was because of falling prices that we had prosperity.  Also, at that time the dollar was exchangeable for gold.

[AgAuMoney]

I guess the deep trend for stock prices is tracking the median wage.

I don't think so.  Stock prices tend to baseline on the value of the company, or discounted future value (time value of money).  In the early 20th, value was primarily determined by dividends paid out, as company financial data was essentially never published.  If the company could pay and grow dividends, it was doing well....  Obviously other factors also influence stock prices, both in the short and the longer term, see below.

As for wages, if the company is doing well -- selling more products, making more money, possibly hiring more people -- people become more valuable to the company and they get more pay.  Otherwise they go find another company that will give them more pay.  More pay, they buy more products.  The economy does better. Etc.  (Henry Ford understood this very well, as well as understanding the importance of pricing to reach customers -- the elasticity of the supply/demand curve.)

(Interesting side-note...  you know why companies started providing other benefits beyond just straight pay?  The benefits which could have been purchased using increased pay were initially added by companies to increase compensation because of labor laws limiting pay and/or tax laws taxing pay -- "freebies" were of greater value to the individual, or cost the company less than they would cost the individual.  So in spite of the increased complexity, providing the benefit was a better deal than simply increasing pay.  Unintended consequences...  So gov't changed the tax laws to tax more benefits.  Etc.)

People talk about demographics of people of investing age governing stock price trends

I do think there is a demographic trend -- increasing investors or decreasing investors will cause increase/decrease in demand which will correlate somewhat with increasing and decreasing stock price, respectively.  The other factor affected will be the price/earnings ratio -- more investors, more demand, bid up stock prices, increase the PE and the converse also.  Simple company growth in profits will not increase the PE, it might even decrease it but will eventually increase the stock price as the investors realize the increased earnings make the company more valuable.

In short, if you see changes in the PE it is due to price changing faster than earnings, or earnings changing faster than price.  If it is due to price changes, you know it is investor demand -- either because of change in the number of investors overall, or because of a change in sentiment for this particular stock (or whatever your PE is measuring, e.g. an index or even a fund).

but deep down it takes a customer base able to pay for the products the companies sell. The developed world has had no real inflation adjusted increases in median wage for 30 years and so increases in stock prices since then look perilously like reversable froth. That period 100 years ago had an emerging class of consumers who provided the customers supporting stock prices. Do we now have little scope for increasing prosperity in the developed world? Are emerging market consumers the new hope?

It definitely takes a customer base, and growth requires increased consumption either from a customer base that is increasing in size or that is increasing in consumption per capita.  (Obviously you can grow profits by cutting costs per unit, that has always ended even before growing consumption.)

I do think future growth will hinge largely on the emerging markets for both sheer number of consumers and consumption per capita.  The U.S. (and to a lesser extent most of the developed world) has fueled consumption with debt.  Our consumption was bound to drop, or at the very least slow down in its rate of growth.

On the other hand, as a dividend investor growth is nice but it is a secondary concern.  If I have a goose that lays 4 golden eggs per week I do not fret about how to make my goose lay 5 eggs per week, then 6 eggs, etc.  (I also do not eat the goose for Christmas dinner!)  Instead, to supplement my egg production, I look to acquire another goose, or maybe a more affordable duck or a hen or even some quail.

To pay for the addition to my flock, I cut my consumption -- instead of consuming all 4 eggs per week, I might cut to 3.5, or 3 or even less.  Once I accumulate the necessary capital then I acquire another bird and then I can safely increase my consumption.  Or maybe I use the added production from my new quail to increase the rate I accumulate capital in order to acquire the duck or the goose I really wanted.

It's quite a different model than debt consumption...  And without easy money from nothing who would loan me money solely to increase my consumption?  Nobody with a brain!  Yet that is what has been happening ("consumer debt").

Of course, I could probably find a lender if I were to create a business plan specifying how the loan will increase my ability to pay back the loan -- I know where today I can buy a goose that lays 4 eggs per week just like my existing goose.  In return for lending me 60 eggs to buy the goose, you, the lender, will get 2 eggs per week for two years (or sooner if I can).  If the goose dies, I will keep making payments using my existing goose, and if the goose lives I get an increase in lifestyle immediately, plus likely even better after I finish paying back the loan.

[smurff]

(Interesting side-note...  you know why companies started providing other benefits beyond just straight pay?  The benefits which could have been purchased using increased pay were initially added by companies to increase compensation because of labor laws limiting pay and/or tax laws taxing pay -- "freebies" were of greater value to the individual, or cost the company less than they would cost the individual.  So in spite of the increased complexity, providing the benefit was a better deal than simply increasing pay.  Unintended consequences...  So gov't changed the tax laws to tax more benefits.  Etc.)

In the United States during World War II, all the nation's resources--raw material and people--were needed for fighting the war and making war products, so the production of heavy consumer goods (like cars, refrigerators, washing machines, etc.) was forbidden.  This lead to shortages of both goods and labor, which brought about inflation.  BTW, the CPI rose by more than 35% during the four years (1941-1945) of WWII. 

The government had several agencies to control production and divert resources, and they were doing better at that than controlling wages.  Eventually the National War Labor Board  was created in 1942; by September of that year the President had the authority to "stabilize" wages and prices by making wage increases illegal.  To get around the law and add compensation to attract workers in a way that would not raise their wages, corporations added things workers had  generally purchased through their own volition, like medical insurance and pensions, or gave them things they generally did not had before, like paid holidays and paid vacation time.  (I think this started in the part of the steel industry with smaller companies, collectively called "Little Steel."  These days the region where Big Steel and Little Steel reigned is called "The Rust Belt.")  The companies called them "fringe benefits."  They paid them lots of overtime, money which did not violate the wage freeze.  As more companies provided the fringe benefits they became contractual parts of collective bargaining settlements and thus survived the war years.

Eventually "fringe" was dropped; these benefits had grown so important that they can no longer quality as "fringe" any more:  Benefits of all types generally constitute about a third or more of an employee's compensation; in some years it can be more than the salary of a particular employee, particularly if the employee has had a major accident, illness or hospitalization.  Now benefits plans are cafeteria plans, with everything from free dry cleaning, free cafeteria lunches, legal services (unless you want to sue the company), eyeglasses, dental services, daycare, 401K Plans (not the same as a pension; traditional pensions are too expensive), you name it. 

Nearly all of it tax deductible by the company and tax free to the employee.  This fact leads to such benefits distorting the markets for many of those goods and services, removing some from the general marketplace (many doctors won't take patients who do not have private health insurance, even if they show up at the office with a stack of c-notes--government insurance like VA, Medicare, Medicaid, Medi-Cal, unwelcome) or at least altering the types of products and services individuals can purchase on their own whether they are employed by a company that doles out benefits or not.