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Further Thoughts on Fractional Reserve Banking and Simple Theft

Summary:
Again, it looks like I’m loading the deck by saying “FRB is like a mugger,” but that’s not the motivation for this analogy… If you haven’t already read it, you should check out my previous post, where I set up a thought experiment to work through the mechanics of FRB, and how it might (or might not) cause the boom-bust cycle as described in the Austrian tradition. Ironically, I created the analogy in that post in order to box Enrico into a corner, thinking he would have to admit that if a simple thief surreptitiously lent gold coins out into the community (without the owner realizing it), then surely this would distort interest rates, and so therefore FRB would do the same, if the depositors acted as if they still had their cash balances available. However, my

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Again, it looks like I’m loading the deck by saying “FRB is like a mugger,” but that’s not the motivation for this analogy…

If you haven’t already read it, you should check out my previous post, where I set up a thought experiment to work through the mechanics of FRB, and how it might (or might not) cause the boom-bust cycle as described in the Austrian tradition.

Ironically, I created the analogy in that post in order to box Enrico into a corner, thinking he would have to admit that if a simple thief surreptitiously lent gold coins out into the community (without the owner realizing it), then surely this would distort interest rates, and so therefore FRB would do the same, if the depositors acted as if they still had their cash balances available.

However, my attempt didn’t work, because Enrico (understandably) clung to an important difference in the analogy, namely that the rich man in my story didn’t know what the thief was doing, whereas people in the modern world are (at least vaguely) aware of what’s going on with FRB.

To add insult to injury, one of the people on “my side”–namely, Dan–also didn’t find my analogy compelling, since in his mind the important thing about FRB and the boom-bust cycle is that FRB creates new money (which hits the loan market relatively early in its life). Since the thief in my original tale wasn’t creating money, but merely stealing it out of a vault, Dan didn’t see how this could be causing a boom-bust cycle in the Misesian framework.

So, in this post let me try to motivate my original idea. But I’ll have to take a detour first, in order to highlight what I think is so special about FRB.

First, imagine a rich guy is walking down the street with 10 gold coins in his pocket. A mugger comes up, sticks a gun in his belly, and takes 8 of the coins. This is certainly immoral and illegal, but it won’t cause a business cycle. The rich man realizes his cash balances have fallen, and so he changes his behavior accordingly. Resources in the economy get reallocated; they now cater more to the mugger and less to the rich man, compared to the original scenario, but there is no reason for the economy to enter upon an unsustainable boom. If, say, the rich man was about to spend those 8 coins on a stagecoach, while the thief instead spends them on a vacation in Barbados, that will simply change relative prices in the economy.

Even if the thief loans the money out, whereas the rich man would have spent it on consumption, that won’t cause a boom. It lowers the interest rate, but that is “correct” in light of the new distribution of wealth. The thief has a lower time preference than the rich man. The rich man has to reduce his consumption (because he just had a bunch of money stolen from him) and that frees up real resources, so the thief’s lending (and pushing down of interest rates) doesn’t cause the capital structure to get out of whack.

* * *

OK, so far so good, I’m imagining. I think Dan, Enrico, and I are all on the same page. Now let’s change things to a standard story of fractional reserve banking. Starting originally from a position of 100% reserve banking on demand deposits, the commercial banks look at all of their customers’ deposits of gold in their vaults, and take 80% of them, and lend them out into the community. This pushes down interest rates. But the original rich depositors don’t alter their behavior. Somebody who had planned on spending 8 of his 10 gold coins still does that. So aggregate consumption in the community doesn’t drop. Therefore, to the extent that the sudden drop in interest rates induces new investment projects that wouldn’t have occurred otherwise, there is an unsustainable boom that must eventually end in a bust.

* * *

At this point, Dan is still with me, but I believe I’ve lost Enrico. Now let me tweak it yet again. Instead of the commercial banks lending out 80% of the gold coins, instead what happens is that a thief slips into the bank vault, and takes out 80% of the coins. But he’s quiet about it, so nobody realizes what happened. The depositors don’t alter their behavior. So long as they don’t all try to withdraw their coins at the same time, the remaining pile of 20% of the coins is enough to satisfy the vagaries of spending/income imbalances.

If the thief lends the money out, won’t that cause a boom-bust cycle?

* * *

I think the thing that’s tripping us all up, is that it’s hard to see what economic function “sterile” money balances serve. In a stable equilibrium of perfect certainty, it’s “wasteful” for a rich guy to hold 10 ounces of gold in his cash balances; he should lend out that money (or use the gold for industrial/consumption purposes) and “put it to work.”

But in the real world, people hold cash balances (partly) in order to keep their options open for future purchases that they can’t know precisely, ahead of time.

So this is why, in my opinion, something is screwy if 100,000 people pool their savings into a common pile, and then they act collectively as if they all still have all of their money available, even though 90% (say) of the pile has been lent out.

Notice how common analogies break down here. For example, the owner of a parking garage can safely sell 1,000 (say) stickers that entitle the buyer to park his or her car in a lot that only has 100 parking spots, if the owner has studied the past and thinks there is only a very small probability that more than 100 people will want to park at the same time. That economizes on society’s scarce resources; it would be foolish to insist on “100% reserves” in such a setting. Let the market do what it will, perhaps with clauses in the contract for what happens if a buyer can’t find a spot. (This is like what happens when airlines overbook, and they have to use an auction to get people to give up their seat.)

But when it comes to cash balances, it seems to me at least that something weird happens if you don’t actually have the cash available. It’s not “wasting” the gold coins for them to be in your pocket even if you’re not spending them in the next 10 minutes, the way it is arguably “wasteful” if there is an empty parking slot with your name on it, even though you have no intention of leaving the house that day.

No, it seems to me that money sitting in your pocket (or in your wallet, your purse, your home safe, your bank vault, etc.) is “providing a flow of services” just by sitting there. It’s not that the money is being wasted until the moment you spend it.

And so in that light, if 1,000 people pool their savings hoping that only 100 of them will want to use them at any moment, that seems economically much different from 1,000 people chipping in to fund a parking garage with 100 spots. The former seems to me that it would cause a mismatch between investment and saving, whereas the latter seems like a clever and efficient leveraging of real estate.

Robert Murphy
Christian, Austrian economist, and libertarian theorist. Research Prof at Texas Tech and author of *Choice*. Paul Krugman's worst nightmare.

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