Rethinking Subsidized Finance

Regular readers know that I view proposals to fund bank asset purchases with high leverage, non-recourse government loans to be an objectionable form of hidden subsidy from taxpayers to private investors and bankers. Calculated Risk agrees.

But John Hempton points out that

all banking capital is non-recourse with the taxpayers — through the FDIC bearing the downside. As long as a fair bit of capital is required (as it should be required for banks) this is not dissimilar to new private money starting banks.

I doubt Calculated Risk would have an objection to that. The issue is not non-recourse — it is the ratio of private to public money because if only a slither of private money is required there is little real risk transfer to the private sector. If a lot of private money is required there is real risk transfer and this plan is the real-deal, but would reduce the chance that the private money could be found.

I gave ratios of 6.5 to one or 7 to 1 because those were about a third where banks were allowed to operate and these funds will hold what on average will be riskier assets. Numbers — not the concept — should be the realm of debate.

I won't speak for CR, but some of us would disagree with JH's presumption that status quo banking with new money would be unobjectionable. Nevertheless, it is wonderful to see put in writing that all banking capital is non-recourse with the taxpayers. Taxpayers write a put option to depositors (and implicitly to other bank creditors), in exchange for a premium in the form of a deposit insurance fee. JH's plea that we should look at the numbers is characteristically on the mark: In option terms, both the value of the bankers' put option and its "vega" — the degree to which its value is enhanced by bank asset volatility — are dependent upon the amount of non-recourse leverage provided.

These are precisely the terms in which we should view the banking industry's quest for every greater leverage over the past decade, with all those SIVs and AIG regulatory capital products and whatnot. They were trading-up, from a modestly valuable, out-of-the-money option written by taxpayers to a near-the-money option whose value could be dramatically increased by taking big chances. It's as if you sold a put option on a $100 asset with a strike price of $85 to someone, and somehow that fothermucker changed the terms of the contract so that the strike was $100 while you were stuck on the other end of it without being paid a dime more in premium. Any private investor would consider themselves cheated by this kind of switcheroo. Banks were robbing taxpayers ex ante, not just during the crisis, by endlessly maximizing their value on zero-sum option contracts with governments caught on the other side.

As even Paul McCulley, the PIMCO dude, acknowledges

it has always been somewhat of an oxymoron, at least to me, to think of banks as strictly private sector enterprises. To be sure, they have private shareholders. And, yes, those shareholders get all the upside of the net interest margin intrinsic to the alchemy of maturity and risk transformation. But the whole enterprise itself depends on the governmental safety nets.

Banking-as-we-know-it is just a form of publicly subsidized private capital formation. I have no problem with subsidizing private capital formation, even with ceding much of the upside to entrepreneurial investors while taxpayers absorb much of the downside when things go wrong. But once we acknowledge the very large public subsidy in banking, it becomes possible to acknowledge other, perhaps less disaster-prone arrangements by which a nation might encourage private capital formation at lower social and financial cost. Rather than writing free options, what if we defined a category of public/private investment funds that would offer equity financing (common or preferred) to the sort of enterprises that currently depend upon bank loans? Every dollar of private money would be matched by a dollar of public money, doubling the availability of capital to businesses (compared to laissez-faire private investment), and eliminating the misaligned incentives and agency games played between taxpayers and financiers who would, in this arrangement, be pari passu. Also, by reducing firms' reliance on brittle debt financing, equity-focused investment funds could dramatically enhance systemic stability.

Private-sector banking has not existed in the United States since first the Fed and then the FDIC undertook to insure bank risks. There is no use getting all ideological about keeping banks private, because they never have been. We want investment decisions to be driven by economic value rather than political diktat, but at the same time capital formation has positive spillovers so we'd like it to be publicly subsidized. How best to meet those objectives is a technocratic rather than ideological question.

In thinking this through, I don't think we should give much deference to traditional banking, on the theory that we know it works. On the contrary, we know that it does not work. Banking crises are not aberrations. They are infrequent but regular occurrences almost everywhere there are banks. I challenge readers to make the case that banking, in its long centuries, has ever been a profitable industry, net of the costs it extracts from governments, counterparties, and investors during its low frequency, high amplitude breakdowns. Banking is lucrative for bankers, and during quiescent periods it has served a useful role in financial intermediation. But in aggregate, has banking ever been a successful industry for capital providers? A "healthy" banking system is arguably just a bubble, worth investing in only if you're smart enough or lucky enough to get out before the crash, or if you expect to be bailed out after the fall.

If banks were our only option, we might think of them like airlines — we've never figured out how to run the things profitably, but we do want commercial air travel, so we find ways to cover their losses. But at least with airlines, the costs are relatively modest, and we constantly experiment in hopes of hitting on a sustainable business model. Despite being catastrophically broken, the core structure of banking has been fixed in an amber of incumbency and regulation since the Pleistocene era. It's long past time to try something else.

Comments

[Chris B:]

"I don't think we should give much deference to traditional banking, on the theory that we know it works. On the contrary, we know that it does not work. Banking crises are not aberrations. They are infrequent but regular occurrences almost everywhere there are banks."
.........................

Banking was working just fine until the bank lobbyist inspired 1999 repeal of the Glass-Steagal Act of 1933. Glass-Steagal was a major reform of the great depression era that mandated that traditional commercial banks (that make money lending to businesses and consumers) be separate from investment banks (e.g. Bear Stearns, Goldman). Following Glass-Steagal and other reforms, the US enjoyed over 60 years of banking stability and the economic growth that resulted from that.

The bank collapses that led to the great depression were caused by banks losing depositors' money gambling on investments (i.e. the stock market). Immediately after the repeal of Glass-Steagal, Citigroup was formed and began funnelling commercial banking assets into the financial markets. BAC and others joined in. Again, depositors' money was being gambled on investments, this time with mortgage backed securities and derivitives. Now, lo and behold, the banks have again managed to lose money, causing them to stop lending to businesses, causing a credit crunch, causing a deflationary depression. That's how mortgage defaults ended up preventing businesses and consumers from getting loans and grinding the whole economy to a halt.

Had we not forgotten the hard-learned lessons of our grandparents, we would not be in this situation today.



"I challenge readers to make the case that banking, in its long centuries, has ever been a profitable industry, net of the costs it extracts from governments, counterparties, and investors during its low frequency, high amplitude breakdowns."
.........................

Traditional banking (accepting customer deposits at a low interest rate and lending to businesses and consumers at a higher rate) has always been profitable if done right (i.e. with high credit and documentation standards). However, history teaches us that combined investment/commercial banks with little or no regulatory oversight will eventually collapse. Whether you have the former or the later depends on what banking practices the laws of your society allow.

More importantly, the counterparty losses banks have inflicted upon society can be more than offset by the economic growth that banking makes possible. Can you build a factory without a loan? Can you pay cash for a new car? Can you pay cash for a house? Can you run a profitable farm without seasonal bank loans? If you want to see a cash-in-hand, no-financing-available economy, visit Honduras sometime.

From the perspective of government, the risks assumed by the FDIC are more than offset by the stable tax revenues generated from the businesses that bank loans normally make possible. Thus, a stable banking system is in everyone's interests.

Hopefully the last 10 years have taught us something about the regulatory environment that is required to have a stable banking system. However, to ignore 60 years of stability because of the most recent 10 years seems shortsighted to me.

Mar 03 03:20 PM

[Bill Herbert:]

>>In any of the two cases, the govt will nationalize the "grid" if any catastrophe of the like blows up and harms lives, almost without a thought. Why won't we do the same to banking industry?

I want to emphasize that we're back to 1997 DOW people!!! And still going back! Talk about time travel backwards economically, sheesh!

With such destruction (more than a decade of destruction in the USA; more than TWO decades of financial wasteland in Japan) wrought, why do we still want to do the same thing?

I agree with the author that banking seems to be a net, capital, money and sanity losing proposition for the whole economic system.<<

Banking works OK if you have honest, capable bankers trying to do the right thing for shareholders, and society, and make a decent living doing that.

Unfortunately, it seems to attract some of the sleaziest elements of the corporate world, looking for get-rich quick deals and obviously open to massive corruption. That's why it needs to be tightly regulated.

When Bush came in, the rule book was thrown away, and the green light for rampant fraud and speculation was turned on. The regulators took long lunches and played a lot of golf on Vegas junkets, sponsored by the bankers!

Then all the $hit hit the fan - now we pay for the most incompetent administration in history.

Sad, isn't it?

Mar 03 03:34 PM

[Chris B:]

"Banking works OK if you have honest, capable bankers trying to do the right thing for shareholders, and society, and make a decent living doing that."
----------------------...
Bill,

Would you rather have the entire economy relying on the honesty and capability of bankers, or laws and actual enforcement to ensure they have no choice but to stay honest and keep systemic risk low?

Call me a pessimist on human nature, but I'd place more trust in a system of rules and enforcement where bankers risked jail time for violations that increase systemic risk. A lot of people are willing to risk being seen as horrible risk managers in exchange for multi-million dollar bonuses. Because the downside risks belong to outsiders as we have seen, outsiders have the right to impose rules on the financial industry.

Mar 04 10:32 AM

[JohnL:]

-- A lot of people are willing to risk being seen as horrible risk managers in exchange for multi-million dollar bonuses. Because the downside risks belong to outsiders as we have seen, outsiders have the right to impose rules on the financial industry. --

Or perhaps the downside risks shouldn't belong to outsiders in the first place -- only the investors. This is why I call for an end to all public subsidies of the banking system; the public's money would not be put at risk and we wouldn't need yet another layer of regulation. I would argue that most of the laws in this country have been written to regulate all of the co-mingling of public and private interests, subsidies, restraints on trade, tariffs, etc.

Mar 04 11:12 AM

[Chris B:]

JohnL,

There is no way to prevent bystanders from being hurt by an out-of-control financial system. Nobody escapes:

-Depositors, in a pre-FDIC world, lost their savings when banks lost money. In a post-FDIC world, taxpayers lose money to make them whole and prevent bank runs.

-Companies lose access to loans when the financial system collapses, which means workers lose access to their jobs! The whole economy contracts without a steady supply of lending for businesses and consumers.

-Even if you're employed for a company that uses no debt whatsoever, your job is still at risk if your customers can't borrow to purchase your product / service.

-If you're retired, your investments in companies unrelated to finance can still be decimated, as we have seen.

But I would agree with you that equity and bond holders in any nationalized bank should be wiped out rather than subsidized. I would also agree that laws and regulations have been mostly made to fit special interest lobbyists' specifications. The 1999 repeal of the Glass Steagal act of 1933 is exhibit A. The people who formed Citigroup spent $600M to get this depression-era reform repealed and set the stage for the current crisis.

Mar 04 01:01 PM

[JohnL:]

On Mar 04 01:01 PM Chris B wrote:

-- There is no way to prevent bystanders from being hurt by an out-of-control financial system. --

That is why I think we need a financial system that is not out of control.

-- Depositors, in a pre-FDIC world, lost their savings when banks lost money. In a post-FDIC world, taxpayers lose money to make them whole and prevent bank runs. --

FDIC is necessary only because of fractional-reserve lending. If you remove that fradulent practice, there is no need for deposit insurance because depositors are already protected from all but fraud or theft.

-- Companies lose access to loans when the financial system collapses. --

This is yet another problem that results from a credit system that can expand and contract (i.e. an elastic money supply). All resulting from fractional-reserve lending.

The constitutional and Austrian solution: end fractional-reserve lending and fiat money. Most all of the problems you cite go away as booms and busts are all but eliminated. Your thoughts?

Mar 04 01:22 PM

[Chris B:]

"The constitutional and Austrian solution: end fractional-reserve lending and fiat money. Most all of the problems you cite go away as booms and busts are all but eliminated. Your thoughts?"
----------------------...

Fractional-reserve lending is borrowing from one person (e.g. $100) to lend to another person at a higher interest rate ($90) while holding only a fraction of the original liability in cash ($10). In a non-fractional reserve system, the person with $100 would have to just directly lend it out. The difference would be that having a third party to arrange loans would be illegal. It is unclear to me exactly how people would finance the purchases of cars, houses, or businesses in a system of individuals making loans. I also have doubts about how efficient or safe such a system would be compared to having professional third parties doing the lending on behalf of investors/depositors. It sounds a lot like the system in many 3rd world countries where there is no lending available to entrepreneurs. They may not have booms, but they have a constant bust.

Regarding fiat money, the free-market price of gold has always been more volatile than the free-market price of fiat dollars. When the dollar was pegged to gold, its value was also more volatile, and impossible to control compared to the value of things like food, other commodities, housing, services, etc. The 19th century featured multiple sharp waves of inflation/deflation that wiped out farmers, industries, and lenders alike. The economic rise of the US from a subsistence farming economy to world leader coincided with the gradual introduction of a more stable fiat dollar.

Overall, economics is an evolutionary process. More successful systems end up with a larger percentage of global GDP and systems based on failed ideas end up with a smaller percentage (For example, communism). The rise of the US was not accidental - it was the result of successful ideas. In the last 10 yrs we've reversed course on many of the reforms, incentives, and yes, regulations and government actions that drove our economy to world leading growth for the previous 60 yrs. We abandoned the winning formula, sort of like Coke II in the 80's!

If a non-fractional reserve, commodity based currency economy would lead to higher economic growth and better stability, why hasn't a country with such a system ever outgrown the US?

Mar 04 05:11 PM

[JohnL:]

ChrisB,

I really appreciate your response. You made some good points, but I want to clarify a couple misunderstandings.

-- In a non-fractional reserve system, the person with $100 would have to just directly lend it out. The difference would be that having a third party to arrange loans would be illegal. --

No, under a 100% reserve banking system lenders can still make loans via a bank. In fact that is one of the traditional services provided by a banker -- he acted as a broker between savers and borrowers. The traditional vehicle was the "time deposit" which paid interest to the saver for a fixed period of time. The only requirement was that the saver couldn't access the money until the term expired, while the funds were loaned out to another party. Credit risk was borne by the banker or the saver, depending on the terms of the contract.

The banker makes money by collecting a brokerage fee or from the margin between the two interest rates. The only difference between our system and 100% reserve banking is that in our system bankers loan out "demand deposits" as well as time deposits. There is nothing to prevent both saver and borrower from accessing the same funds. And this divergence between true savings and credit is what enables the boom-bust cycle.

-- When the dollar was pegged to gold, its value was also more volatile, and impossible to control compared to the value of things like food, other commodities, housing, services, etc. The 19th century featured multiple sharp waves of inflation/deflation that wiped out farmers, industries, and lenders alike. --

Many observers of that period (and earlier ones) recognized that the volatility was not caused by gold backing -- but the fractional-reserve lending that was layered on top of gold reserves. The growth in the supply of gold has been quite stable over the centuries with only two exceptions: Spanish gold imports from the New World and big gold discoveries in CA and AK. Those disruptions are behind us an unlikely to repeat. I would refer you to almost any book on monetary history to see that this is true. One I enjoyed was "A Short History of Paper Money and Banking in the United States" by William Gouge.

-- Overall, economics is an evolutionary process. More successful systems end up with a larger percentage of global GDP and systems based on failed ideas end up with a smaller percentage (For example, communism). --

I agree completely, if all systems are allowed to compete fairly. But politicians and bankers are able to achieve local maximization of benefits (their own) because they are in power. They use their laws (e.g. confiscation of gold by FDR; tax on purchases with gold; legal tender laws) to prevent the adoption of gold as a currency.

-- If a non-fractional reserve, commodity based currency economy would lead to higher economic growth and better stability, why hasn't a country with such a system ever outgrown the US? --

I'm not aware of a country that has allowed such a monetary system. Politicians and bankers throughout the world have been united in their opposition to such an economy for 500 years or more.

Mar 04 08:33 PM

[Aristophanes:]

On Mar 04 08:33 PM JohnL wrote:

> ChrisB,

> -- If a non-fractional reserve, commodity based currency economy
> would lead to higher economic growth and better stability, why hasn't
> a country with such a system ever outgrown the US? --
>
> I'm not aware of a country that has allowed such a monetary system.
> Politicians and bankers throughout the world have been united in
> their opposition to such an economy for 500 years or more.

The latter piece is historically and contemporarily inaccurate. Today, collateral and commodity-based neighbourhood banking systems dominate the developing world at the local economic level. Most third world citizens do not have banks accounts in their regulated currency; they are almost exclusively reserved for government officials and businesses involved in the import trade. Citizens are 10x more likely to have a cellphone. Instead they participate in secondary depositor and collateral systems, like the famous We are talking about 60% of the Earth's population living in countries where the currencies barely trade internationally (or do so only to pay IMF/World Bank loans). For all the talk of globalization, when it comes to commerce, 90% of the world's currencies make up less than 0.2% of all Forex trades.

The collateralized and 100% commodity system is awful, responsible for much of the severe corruption i the third world. There are very few deposits to draw upon so in order to borrow, you must have equivalent collateral (the book/movie Rob Roy has this as the central ethical theme). In fact, the economic system in most developing countries is still based on forms of primogeniture (inheritance, dowry) and debts are carried across generations. This is a direct consequence of commodity economic systems when applied to collateral. (And one could argue, for debtor's prisons as tying repayment to anything more than a fiat currency leads to the abuse of physical labour as collateral, or its converse, the denial of personal liberty as payment in kind).

The entire concept of bank deposits was started because of fractional reserve lending opportunities. You've got it backwards. There has never been a banking system as we know it that has been anything but fractional reserve. A full reserve system is purely hypothetical. Even the Austrian School has never reached consensus on that point.

My background is that of an authority on Classical and Medieval history (hence my nickname). One of the key transitions to the modern era was the development of banking structures that have always been fractional reserve. Always. There has never been a "100% reserve banking system" in a truly modern, developed economy. Anyone who says or writes otherwise is a fraud who has not read primary source historical documents on the evolution of commerce, or has reinterpreted history to fit some bizarre, ideological, economic utopia.

A "non-fractional reserve economy" is that of Imperial Rome circa. 60 A.D. I know because my field of expertise is comparing the coinage economies from the Ancient/Medieval with contemporary developing world coinage and economic systems. I have spent years abroad studying these "100% reserve systems" (all collateral really because 99% of citizens have assets that readily be bartered as it can be sold for a currency). None of them create economic progress. In fact, they severely inhibit progress because unless the commodities increase at the same rate as population then there is redistribution tension, and always violent conflict. The lack of faith in fractional reserve banking kills their fiat currencies and they drop down the ladder swiftly to bartering their collateral (working capital really) rather than depositing it. Thus, there is no banking system. I would rather have today's mess than the economic insecurity of most developing countries.

India is the prime example. Awash in gold even amongst the lower castes, the barter trade in gold (ever been to an Indian funeral?) usurps the fractional lending system to the point where the articles of value circulate but cannot be leveraged. Putting their gold up as collateral for a paper "note" is risking the family's entirety. As a metaphor, it's their "seed" money. Therefore it is culturally, ethically and economically abhorrent to underwrite the currency with the most valuable commodity—economic security. That is why it is personally held as jewellery. It doesn't work to advance economic day-to-day activity because hoarding and bartering replace risk and leverage. Growth was unbelievably slow, despite population increases. Only since India has been forcing the fiat paper for all transactions within a fractional reserve lending sysem has the country been able to grow out of its medieval economic architecture. In fact, modern Indian banks in the UK, America, Canada, Australia, etc. often allow for the direct deposit and shipment of gold, so long as the account holder also participates in the modern banking system—meaning fiat money and fractional reserve lending. They are parallel structures: one preserves cultural value and acts as a hedge against family calamity (and infertility), the other promotes economic growth. It's official policy and since its inception India has been on a development tear that has lifted the well-being of hundreds of millions of people. Until the government forced the fiat currency system, their gold system actually led to relative declines in material prosperity.

Also, you are wrong about the surges of gold into economies. Historically the pulses of gold and silver discoveries have been sporadic though quite common and generally very, very unsettling contributing greatly to conflict. The Crusades, the gold trade paralleling the slave trade from West Africa, Athens vs. Sparta, these all had a portion of their conflict the forcible redistribution of hoarded commodity wealth, largely gold. The oft-quoted modern parallel is the "black gold" of oil. You want that volatility for a currency? There's a valid reason why it was given that name, just as paper notes replaced actual commodities and eventually became independent of them. Currencies liberated from commodities are far superior to those tied down. That does not remove gold as a valuable currency in its own right, or as Plan B; its just that the gold standard and fiat money are better left as separate entities, each with their own dynamic.

There are dozens of examples in the history of economic development that completely refute your perspective JohnL. Sorry.

______________________...

Nice post Chris B. Very well put.

Mar 05 01:06 AM

[Chris B:]

Excellent discussion JohnL and Aristophanes. A rare example of Austirans and non-Austrians having a smart, civil discussion on SA!

Mar 05 09:57 AM

[JohnL:]

Agreed! Thanks Aristophanes, for a credible argument on this subject. Guys it will take me a day or so to respond properly, but I will so please check back.


On Mar 05 09:57 AM Chris B wrote:

> Excellent discussion JohnL and Aristophanes. A rare example of Austirans
> and non-Austrians having a smart, civil discussion on SA!

Mar 05 11:32 AM

[Aristophanes:]

Thanks guys. The Austrian school can spot a bubble a mile away and I respect them for their clarity. They also have a healthy disrespect for formal modelling within the "dismal science", and that's been proven accurate of late. Years ago when Bernanke spoke about the "end of the business cycle" the historian in me cringed. He's supposedly a historian! Yet Peter Schiff clinically nailed the coming housing bust with textbook accuracy.

That said, the posited Austrian solutions are simplistic, rigid, unproven, poorly modelled themselves, and ahistorical. Like Marxism, they make a great tool for critical analysis, but lousy rules to live by. When the Austrian Schools tries to be the conventional wisdom, they fail. They are better off on the outside looking in.

Other examples of conflict caused by commodities: the Boer War and the current, horrific conflict in the Eastern Congo.

Also, in my long rant I left out the term Hawala system, after "famous".

Mar 05 01:33 PM

[JohnL:]

Aristophanes,

Could you please clarify your meaning for a "collateralized and 100% commodity system?" Are there any differences between that and a "100% reserve banking system" or are they equivalent in your mind? Some of your comments might imply that the former suffers from a lack of available deposits and loan contracts that impose oppressive terms on the borrower (even liabilities passing to the heirs of the borrower).

Mar 05 05:25 PM

[Aristophanes:]

It doesn't mater what the "banked" commodity is. It could be gold, jade, US$, koi, or cattle. It depends on the local store of value. If you then issue a note against that value, you've created a currency. I've been in African countries where photocopied US $20 bills were traded at half value (US$10), and they had a better store of value than the local currency.

There are no bank deposits in a system where barter is as valuable as monetary transactions. Why expose yourself to accounting rules and the taxman, the whims of a corrupt government, skimming bank managers, or the Forex market when you can avoid these institutional pitfalls? Or, why lend in any currency when real collateral and generational debt have far more tangible payback? The lack of faith in fiat currencies kills commerce in developed countries because they cannot leverage their deposits against future earnings but against present capital accumulations only. Fractional reserve lending builds in a risk tolerance towards default with the expansion of credit, roughly based on demographics and human productive ingenuity, not how much of a precious metal is mined in some far off place.

That is why there is an IMF and World Bank. They basically use the world's reserves currency (the US$ and reserve drawing rights) to finance development. This is the germ as to why the Euro came into being. When a decline occurs in a fractional reserves system, the majority of losses are taken against future earnings.

In the developing world where barter is relatively available as a substitute for currency transactions (Southeast Asia during the 1997 crisis saw an explosion of regional bartering), debt is registered as collateral at extremely usurious rates. In a fixed commodity system, if you want to add a productive second milk cow, the rates are absolute. You cannot break down a cow into parts so you have to put the entire first cow up for collateral. If cow two dies before the milk can be sold to pay for the purchase, you also lose all of cow one. That's how famines happen. We have a term for it—betting the farm. (And what happened to the Okies in the 1930's—sharecroppers had no credit to purchase seed, so when they lost a crop, they were evicted from their subsistence farming and starvation ravaged America). In a fractional reserve system it is entirely possible to lend with no collateral (almost unheard of in developing countries until micro-lending came along) because the risk pool is evaluated against the possibility of future earnings. Who cares how much the the pegged commodity is worth? The only thing that counts is the faith in the productive capacity of the recipient. If they know cows and have no collateral, you can still lend them money because they know cows. That's the value. Forget about basing their worth on the last ten generations ability to hoard gold. That agenda is counter-productive and in areas of high population growth, leads to enormous disparity in wealth.

Indians store gold as a safeguard against crop failures and infertility (generational support), not as currency. They'd never forego their seed money. As such, gold is not leveraged for risk, but is hedge against risk. It is insurance. Using it as a standard to underwrite currency as with a gold standard risks all deposits to the aforementioned corrupt government, or invader, etc. This lack of risk taking is severely inhibiting to commercial development. That is why micro-lending has been so successful there. It breaks the cycle of reliance on gold and introduces risk-taking based on the community measure of individual productivity. Failure is built into the model in terms of higher rates, but there is no need to peg the value to a family's gold. That is specifically excluded as collateral precisely to increase the assessment of productivity, not against generational wealth accumulations. It breaks the caste system and its roots in primogeniture. It's a very interesting development because it moves local commerce beyond the commodity-fixed, Medieval, economic architecture.

Fiat currencies and fractional lending liberate transactions from physical repercussions. That is how bankruptcy evolved to replace debtor's prisons, and before that slavery, serfdom, sharecropping, the caste system, and so on. Yes, fractional reserves are risky as we see now with liquidity traps, hyper-inflation, and sub-prime idiocy. All systems are. Today's crisis is about how banks, lobbyists, those in favour of de-regulation (starting with the whole Reagan/Thatcher "government is the enemy" agenda), broke the social contract about acceptable systemic risk and abused leverage to the detriment of the body politic. This about good governance gone bad.

Mar 05 09:43 PM

[JohnL:]

Aristophanes,

Long post alert! My comment is really too long for a blog, but I don't have your email address, so here goes...

First of all, like most Austrian economists, my arguments are primarily theoretical and not based on empirical evidence. I’m sure you know that the Austrian school believes that most historical economic data is influenced by too many concurrent variables to draw “scientific” conclusions. In short, national economies are not good laboratories so you can’t run good experiments. To call economics a science is generous at best. Nonetheless, I’ve attempted to respond to your empirical claims.

-- Today, collateral and commodity-based neighbourhood banking systems dominate the developing world at the local economic level...The collateralized and 100% commodity system is awful, responsible for much of the severe corruption i the third world. --

You seem to be suggesting that the developing world offers us many examples of full-reserve banking to examine, and that the record is one of failure. I believe there are many more likely causes for the economic issues of the developing world, as described below.

How does full-reserve banking cause corruption? Indeed, the Austrian position is that fractional-reserve banking is in fact a form of legalized embezzlement, since money supposedly available to the depositor “on demand” has in fact been loaned out for profit by the banker. This system offers tremendous opportunities for corruption as the elite has access to tremendous amounts of credit prior to the average person. Indeed, in Barcelona of the 14th century the penalty for a banker caught engaging in fractional-reserve lending was beheading.

-- None of them (commodity systems) create economic progress. In fact, they severely inhibit progress because unless the commodities increase at the same rate as population then there is redistribution tension, and always violent conflict. --

First, commodities generally do increase at the same rate as the population, and gold is no different than others. The amount produced is self-correcting: when the price gets too high it stimulates mining and when the price gets low it depresses mining. Second, a little variation in the amount of gold is insignificant compared to the wild swings (mostly upward) we face with fiat money and fractional-reserve credit.

-- There are very few deposits to draw upon so in order to borrow, you must have equivalent collateral...There are no bank deposits in a system where barter is as valuable as monetary transactions. --

I agree. We both seem to agree on the need to encourage saving and the investment of those savings which the saver is willing to put at risk. Our disagreement seems to center on what constitutes available savings and the factors which encourage their prudent investment.

-- Using it (gold) as a standard to underwrite currency as with a gold standard risks all deposits to the aforementioned corrupt government, or invader, etc. This lack of risk taking is severely inhibiting to commercial development. --

If the government is corrupt, there is no protection for the citizen in any case. Using a different type of money does not change the protection level. And if invaders come to loot the country, they will take the gold whether you call it money or not because it is valuable. Indeed, corrupt governments have always favored fiat currency over gold because it is easier to counterfeit…eh…I mean easier to create.

-- Putting their gold up as collateral for a paper "note" is risking the family's entirety…Indians store gold as a safeguard against crop failures and infertility (generational support), not as currency --

So Indians, based on the variability of their farm income and their risk tolerance, keep a large portion of their savings in a liquid form (gold), rather than taking on the credit and liquidity risks of investing those savings. How can that be attributed to fiat money or the lack of fractional-reserve banking? It seems to be more the result of cultural differences and the unpredictability of the monsoons. Would changing their money system increase their risk tolerance or smooth out the rains?

-- That is why it is personally held as jewellery. --

This may actually be as much a result of religious doctrine pertaining to a woman’s right to own property or investments, as it is to fear of investment risk.

-- There are very few deposits to draw upon so in order to borrow, you must have equivalent collateral --

Why would full-reserve banking discourage deposits by savers? Indeed, the primary reason for a “bank run” is a fear that the fractional-reserve bank can’t honor your withdrawal request; this doesn’t occur with full-reserve banking.

The lack of good banking in the third world today is not proof that such banking has never existed or cannot exist; there are many other factors, like the lack of respect for the rule of law and political instability, to account for their unwillingness to deposit savings and their economic troubles.

-- …and debts are carried across generations (as a result of commodity-based banking) --

Aren’t you ignoring the role played by modern bankruptcy laws and the legal construct of limited liability in encouraging risk-taking? I don’t see a (negative) relationship between full-reserve lending and the frightening consequences of debt default. If anything, full-reserve banking eliminates the systemic failures (debt deflation) that we are currently experiencing, since defaults don’t contract the money supply.

-- The lack of faith in fractional reserve banking kills their fiat currencies and they drop down the ladder swiftly to bartering their collateral (working capital really) rather than depositing it…Fractional reserve lending builds in a risk tolerance towards default with the expansion of credit, roughly based on demographics and human productive ingenuity, not how much of a precious metal is mined in some far off place. --

As explained above, the increased risk tolerance comes from legal protections – not from a greater willingness to risk paper money than to risk other forms of wealth. Increasing the supply of “credit” or fiat currency produces the illusion of an increase in investable capital. This illusion causes entrepreneurial error because there is actually insufficient capital in the economy to complete many investments started as a result of the illusion. Full-reserve banking ensures that all credit represents truly investable savings.

-- In a fractional reserve system it is entirely possible to lend with no collateral (almost unheard of in developing countries until micro-lending came along) because the risk pool is evaluated against the possibility of future earnings. --

Credit risk is always evaluated against the borrower’s prospect for future earnings and requiring loan collateral does not result from full-reserve banking. It results from the lender lacking sufficient confidence in the borrower’s future income stream and his ability to repay the loan principal and interest. We have many loans in the fractional-reserve world that still require collateral: mortgages; auto loans; small business loans. I don’t see that you’ve demonstrated causality on this point.

-- If they know cows and have no collateral, you can still lend them money because they know cows. --

Even in a full-reserve banking system, a banker will be willing to make a loan if there are good prospects for future earnings. Why wouldn’t he lend investable savings to a borrower with a good business plan? The form of money loaned doesn’t change his risk, does it?

-- The barter trade in gold usurps the fractional lending system to the point where the articles of value circulate but cannot be leveraged… gold is not leveraged for risk, but is hedge against risk. It is insurance. --

If gold is acting as a medium of exchange, then that economy is not based on barter. If it is a barter system, then there is no banking system – fractional or otherwise.

And are you claiming that society resorts to barter because of the acceptance of gold as money? I don’t believe this is historically accurate. Precious metals, because they were so good in their role as money, eliminated most barter systems thousands of years ago, where political conditions were sufficiently conducive.

Also, savers in all financial systems face the decision of how much of their wealth will be kept in liquid form and how much will be committed for longer terms. They also must choose a spot on the investment risk-reward spectrum. I don’t see how using gold as money alters those decisions. If anything, knowing that they will be repaid in a stable currency will reduce one of their primary risks. If they are less willing to loan gold perhaps it is because they know gold is more valuable than fiat currency.

-- The lack of faith in fractional reserve banking kills their fiat currencies… --

On this we both agree. It is one of many reasons for abolishing fractional-reserve banking; it undermines faith in any type of currency placed on deposit.

-- Fiat currencies and fractional lending liberate transactions from physical repercussions…tying repayment to anything more than a fiat currency leads to the abuse of physical labour as collateral... --

I don’t see how the currency specified in the loan contract impacts the repercussions of default for the borrower. Whether or not the creditor can lay claim to the borrower’s collateral is a function of the legal system and the contract terms – not the specified currency of payment. If the laws allow it, a borrower can be equally wiped out in fiat currency, gold or cattle. Debtor prisons went away because of changes to debtor laws – not because of the move toward fiat currencies or fractional-lending.

-- There has never been a banking system as we know it that has been anything but fractional reserve. A full reserve system is purely hypothetical. The entire concept of bank deposits was started because of fractional reserve lending opportunities. You've got it backwards. --

First of all, you can’t describe at length why a full-reserve banking system is “awful” and then claim one has never existed. Conversely, if there are important differences between a full-reserve banking system and a “collateral and commodity-based system” then the failure of the latter can’t be used as evidence against the former. I operate under the assumption that you hold them to be different in important respects.

Secondly, I will confess that I’m not an academic researcher with access to primary source documents, so I’m relying heavily on the research of others.

We know that banks and the state have cooperated in their pursuit of fractional-reserve banking for centuries. This helps explain why there are few long-running examples of full-reserve banking in modern times. That said, we know that bank deposits and full-reserve banking have existed, at various times and places, for more than two-thousand years.

We know that full-reserve banking was established and protected by early legal precedent. The ancient Greeks conducted deposit banking in the temples and deposits could not be loaned out by the bankers. In 293 B.C. the legal scholar Isocrates describes a trial of a banker in “On a Matter of Banking,” p. 114. The client testified that his banker “cried and said he had been forced by economic difficulties to deny my deposit but would soon try to return the money to me; he asked me to take pity on him and to keep his poor situation a secret so it would not be discovered that he had committed a fraud.”

Todd, in “The Shape of Athenian Law,” p. 251, indicates that “banks were not seen as obvious sources of credit…out of hundreds of attested loans in the sources only eleven are borrowed from bankers; and there is indeed no evidence that a depositor could normally expect to receive interest from his bank.”

Rostovtzeff in “The Social and Economic History of the Hellenistic World” p. 1279, indicates that bankers in Ptolemaic Egypt accepted both demand deposits and interest-paying time deposits.

We know from classical Roman law that the concept of a demand deposit was well-established in Rome. Section 3, book 16 of the “Digest” of “The Corpus Juris Civilis” is entitled “On Depositing and Withdrawing.” In it Papinian declares of deposits that a banker must “return them to you immediately, whenever and wherever you wish.” In the same book

Ulpian describes the legal protections for depositors: “Whenever bankers are declared bankrupt, usually addressed first are the concerns of the depositors; that is, those with money on deposit, not those earning interest on money left with the bankers.“

It may very well be that the Greeks and Romans tried and eventually rejected fractional-reserve lending, but there can be no doubt that full-reserve banking was established practice in the western world a long time ago.

After the fall of the Roman Empire, Europe fell back into a system of barter for many centuries. But when banking finally returns late in the Middle Ages, it follows Greek and Roman legal precedent.

Piquet in “Bankers of the Middle Ages: The Templars, a Study of their Financial Operations” tells us that the order of the Templars provided deposit banking services throughout their area of influence starting in the 12th century and that they did not loan out demand deposits.

Usher in “The Early History of Deposit Banking in Mediterranean Europe” indicates that the move from full-reserve lending to the use of fractional-reserves does not become widespread in Europe until the 13th century. On p.63 he states that banks in 12th century Genoa made a clear distinction between demand deposits and time deposits, and recorded the latter as loans or “mutuum” contracts.

The Bank of Amsterdam, founded in 1609, operated exclusively on gold and gold certificates, and did not loan out on-demand deposits. It operated profitably for hundreds of years.

It is clear that with the protection and participation of government, full-reserve banking has gravitated toward fractional-reserve banking. This is not in dispute. The central questions are whether full-reserve banking, in which demand depositors are protected, ever existed and whether it is a good or bad thing.

-- Historically the pulses of gold and silver discoveries have been sporadic though quite common and generally very, very unsettling contributing greatly to conflict. --

Today, gold has an extremely high stock-to-flow ratio. Such disruptions are undoubtedly a thing of the past. Thus, the parallel drawn with oil, which has an extremely low stock-to-flow ratio, is not warranted in a monetary context. Most of the events that you cite are political in nature and could just have easily occurred with any form of money. In any case, I would not dictate that only gold or silver can be money, but that they be allowed to compete freely in the marketplace, unfettered by governmental restriction.

-- Currencies liberated from commodities are far superior to those tied down. --

I believe you have it reversed. In playing its role as a reliable store of wealth, a currency tied to commodities is superior to a fiat currency. When government can (and they always do) print currency without restraint, that currency is not a reliable store of value. This causes a society to lose faith in the currency and revert to barter in an attempt to gain protection from inflation. An unstable currency also increases the risk associated with credit contracts, particularly for the lender. Both factors diminish capital formation and economic progress.

Again, my apologies for the length of this posting. If you want to continue the discussion, perhaps email would make more sense. jlafer at yahoo dot com

Mar 06 06:26 PM

[Aristophanes:]

JohnL:

Full reserve banking in Ancient and Medieval times was anything but, and not at all comparable to modern banking systems which evolved from the later Middle Ages, spreading forcefully throughout Europe and the Near East afterwards, primarily through Venice and Genoa.

Ancient banking systems were mostly repositories for the nobility to keep the coinage of the state, corresponding to their roles as guardians of political office. Coinage and note lending was done mostly amongst the noble classes. The patrician/plebian dynamic was the real mechanism for wealth redistribution. Coinage economics were extremely rudimentary and were secondary to barter at local levels. In Rome, coinage was a way of enforcing military rule: local merchants were forced to accept the coins as presented to them by the Legions for the exchange of goods. Almost all local commercial lending was done using barter collateral, not deposited coinage, although in urban areas coinage was accepted in terms, barring a coup. Full reserve banking was an arm of the state. It was a way the military maintained central order and kept the troops loyal. Unless they were out pillaging, that's how they were paid. Coins were partially solvent in their own right, but the dissuasion to reformulate was to imprint the image of a god on them, thus making it a traitorous crime and blasphemy to alter. Of course, the Roman Emperor was that god.

Commoners use of banks was non-existent and their economic structures were closer to what we see in the developing world today, including loan sharks and other formal and informal civil agreements. Loans were made using hard collateral (rarely deposited coinage—no one trusted the Emperor du jour) and the failure to pay was punished by enslavement. The most extensive use of what we would call banking comparable to modern terms was in shipping and insurance, where the Romans in particular were ingenious in their application of merchant capital and bourses to trade risk (the nobility controlled the armies, political offices and priesthoods, but navies and the merchant marine were landless and ephemeral in power, so offer an interesting counterpoint to the baseline system).

There has never been a full deposit system that survived into modern times because the systems cracked under the stress of capital expansion, vastly outrunning the input of depositors. Political insecurity destroyed fixed location capital depositories. They were blatant targets. That is how monasteries evolved into fortresses.

In fact, the noblesse oblige arising out of the late Medieval period in all likelihood precipitated the rise of fractional reserve banking. The landed nobility, owning upwards of 95% of the productive capital of society, invested only in farmland, eschewing other productive endeavours, and only reluctantly financing exploration and new technologies. Land equalled nobility and all the political and family privileges therein. They equated banking with the state treasury and acted as such in jurisprudence (they controlled the courts) and contract law (they were the rule of law) and the ever-present taxes (they were the tax collectors).

Bourgeois urban merchants were the creators of fractional reserve banking, especially in Northern Italy. This enabled risk based on ability to take both profit and loss out of future earnings and productivity; not out of generationally hoarded caches of treasure and land attached to title, the latter of which could be used to politically "get out" of contracts. These bourgeoisie saw a need, worked the math, and created the dynamic economic structure of monetary commerce we now live in. They were oppressed by the centralized economic notions that all wealth really belonged to the state a la the Sun King mentality (there is your "embezzlement"; God said so and gave the King supreme powers). Therefore they created a system of lending that took advantage of their meagre capital reserves, multiplying the productivity of money. Their risk to reward ratio of their systemic advance easily trumped the capital gains of the nobility stuck on the same land generation after generation, fending off rising problems with overpopulation, revolt and famine.

Historically, fractional reserve banking is an unqualified success. The history of Western progress is absolutely linked with this evolution. Fractional reserve banking grew out of opposition to noble government by a growing middle class. You have it entirely backwards when you assert that the state "participated" in its formation. These merchants were running away from the constraints of the state. This is the same reason why fractional reserve banking is allowing developing nations the freedom to experiment and take risk based on human capital and not on fully backed deposits (unless you have the centralizing corruption of the likes of Macos, Suharto, Banana Republics, etc.). It's a powerful social contract that evolved overtime based on need. It was not at all a top-down concept. There has hardly been a "500 year opposition" to a full reserve economy because the fractional reserve system was in itself the triumphant revolution from centralized control based on a landed gentry determining what the measure of wealth and commerce were (it's gold and only gold, dang it; no, wait, tulips; no, it's whatever Louis says). The explosive advance of the European merchant class was the result. There would not be a United States without that event. If the Austrian School promotes that historical read, they've got it wrong. That is simply not how the history unfolded. You need to get out of the ideological straightjacket.

I will gladly accept a banking system where my deposits can be fractionally leveraged for investment n my citizen peers. I believe in the productive capacity of my citizen peers and know they are good for it. It's a risk factor I am entirely comfortable with even if abuses do occur. The idea that we can only lend out no more than what we deposit is defeatist and ahistorical, and frighteningly Medieval in its rigidity. Frankly, a full reserve system never going to happen. Fractional reserve banking is far too flexible and entrenched to be usurped by unproved ideologies. Any transition towards such a system would lead to extreme violent, the end of which would find no gold anywhere, it all being hidden in holes somewhere deep. Fractional reserve banking has taken on its share of crises, and the world has progressed. As for fiat currencies; their value is gained from the rule of law. That, too, has been generally progressive over the last 500 years, so I'll trust in that as well.

Thank-you for the discussion.

Mar 06 10:24 PM

[JohnL:]

Aristophanes,

I really appreciate your quick reply and the obvious effort you took in responding. Unfortunately, while you tell a compelling story, none of it is backed up by source references. And frankly, I had a hard time following your logic. Also, you did not respond to most of the points I raised, so I’m left with more questions than when I started. Here are some specific points that for which I would love a response, if you’re so inclined:

I provided multiple references showing that deposit banking and full-reserve banking were established by legal precedent in classical Greek and Roman law. Are you disputing them?

I provided multiple references showing examples of full-reserve banking practiced in Europe. Are you disputing them?

How does using gold as money lower the saver’s risk tolerance or raise his liquidity preference?

How can an unwillingness to lend be attributed to commodity-backed money or full-reserve banking?

Requiring loan collateral does not result from full-reserve banking, but from poor credit risk. Most loans in our fractional-reserve system require collateral, do they not?

How does full-reserve lending make worse the consequences of debt default for the borrower?

Investment risk-taking by borrowers increased primarily due to changes in bankruptcy laws.

How does full-reserve banking cause corruption?

Full-reserve banking eliminates systemic failures caused by bank panics and debt deflation.

Increasing the supply of “credit” or fiat currency produces only the illusion of an increase in available capital. This leads to entrepreneurial error.

Commodities generally increase at the same rate as the population.

With regard to your latest comment, you talked a lot about the extensive use of barter. I’m not defending barter systems, I’m not proposing that we go back to them and I’m not convinced that using gold-backed money leads an economy back to them. I'm afraid you’ve lost me on that one.

You state “There has never been a full deposit system that survived into modern times because the systems cracked under the stress of capital expansion, vastly outrunning the input of depositors.”

First, I never claimed that deposit banking or full-reserve lending survived from ancient times to the present. In fact, I understand that most all banking ceased during the Middle Ages.

Second, are you saying that growth of tangible wealth outpaced that of the money stock, leading to deflation? I don’t think that is historically accurate. There are numerous examples of inflation caused by credit expansions in early fractional-reserve economies. Among them: the inflation in Florence that preceded the banking collapse of 1341-46 and the inflationary policies of the Medici bank from the 1460s until its collapse in the 1490s. There were deflations and collapses, but I think they were all preceded by credit inflations that could not be sustained.

And can you demonstrate that deposit banking caused this “stress” which led the “system” to “crack?” As a counter example, the Dutch flourished during the period when their banking system was dominated by the Bank of Amsterdam – from 1609 until after 1800. This bank, as was described appreciatively by Adam Smith and David Hume among others, operated as a full-reserve lender until at least the late 1700s. In 1699, the French ambassador described the city: “Amsterdam is without any doubt the foremost in greatness, wealth and the extent of her trade. There are few cities even in Europe to equal her in the two latter respects; her commerce stretches over both halves of the globe, and her wealth is so great that during the war she supplied as much as fifty millions a year if not more.” Their full-reserve banking system does not seem to have been a problem.

-- You have it entirely backwards when you assert that the state "participated" in its formation. These merchants were running away from the constraints of the state. --

Did not the state provide the banks their charters and licenses? Did they not set up and enforce the laws which permitted fractional-reserve banking to flourish, counter to legal precedent handed down from Greek and Roman law? And I think state participation can be seen directly when the government entered the banking business itself. Examples: the Taula de Canvi (Barcelona’s Bank of Deposit) in the 15th century; the Bank of Stockholm in 1668; the Bank of England in 1694, which was effectively a government bank.

-- Historically, fractional reserve banking is an unqualified success. The history of Western progress is absolutely linked with this evolution. --

The list of inflations, deflations, bank failures and disruptions of commerce under fractional-reserve banking is as long as your arm. I’ll be happy to provide a list if you like, but there’s no secret on this point. Yes, there has been Western progress, but you’ve not shown causality between it and the banking system, and I don’t think anyone can (given all the social, political and scientific variables at work).

I look forward to your response. Thanks.

Mar 07 03:55 AM

[Leonard C.T...:]

Economic Crisis Problem Finally Solved

CSUB Professor of Economics Mark Evans was quoted as saying, "We are going to have to live with large deficits for a long time, and there is no other way." I disagree with that statement. I believe there is another way out of the Economic Crisis. I have over 40yr of being in the financial world. President Obama and Professor Evans are relying on Keynesian Economics. John Maynard Keynes created these economic policies in the 1930s. Many economist of his time disagreed with him, but it turned out he was correct, in his time, in an inefficient way. His policies, put governments into massive debt, more government programs are created. Over the years, larger and larger governments are developed. His policies work but he did not leave a handbook behind on how to correctly slow down the economy when it is so strong that it is creating an economic crisis. Our economy is in economic crisis. Not from being too strong but from being too weak, after a very strong period.

President Obama is once again applying Keynesian Economics to the problem. Our economy has changed tremendously since the Great Depression. The economy has become so large and electronically sophisticated, that we need new methods of correcting economic crises. People have become more aware of credit use, which expands the money supply without government spending. The Government just has to have the right policies in place at the right time in the economic cycle for the economy to work efficiently. The old ways do not work any more. We have to try something different. What the government is doing is not working!

What is recession? A recession is caused by excessive supply created by over production. Recession is also created by insufficient demand because of insufficient available cash purchasing power. Recession is also the inability or desire of people to obtain credit because of a lack of confidence in the future or it has become too expensive or restrictive. This causes an insufficient amount of money value in the economy, resulting in people not having sufficient cash purchasing power to exchange for new produced value. It feeds upon itself further decreasing economic activity every time some one loses their job. The idea is to increase economic activity so people can go back to work and take care of themselves and their families, increasing their purchasing power there-by increasing demand. A majority of Americans enjoy their freedom and want to earn a living without government interference. If you are going to say people abused the credit system. I agree with you. A home should be valued for the protection it gives you from the weather and the security it gives your family.

I have developed new policies that correct economic crisis, such as recessions, inflation, and depressions, in a more efficient way. My desire would be for you to read the Alternative Economic Stimulus Plan. It is not over a 1000 pages like President Obama’s Economic Recovery is. It is posted at americansolutions.com Put "happyashell" in the search box. There are several articles, I would start with THE VULTURES ARE CIRCLING. There I hope you will find answers to the questions. How did we get ourselves into this economic crisis? How will we get ourselves out of this economic crisis? I believe that unless Congress hears from the people we will continue reliving history with gloom, boom, and doom economics.

THE VULTURES ARE CIRCLING

The value of our homes has been the backbone of our money supply. If you presently owe more than your home is worth the vultures are circling. The bankers and investors servicing your loan want you to make payments on a loan that may be more than what your home will sell for. The vultures are waiting until you default on your loan, to pick the economy’s bones clean. The housing bubble has burst and prices are coming down. This has led to federal action to stabilize and re-inflate the housing market.

The government (your representatives in Washington) should change the tax policy for bank business losses, so banks are motivated to lower the principle balance of your loan. We should support President Obama as he lowers interest rates and pays banks or investors one-half of the amount that is forgiven on each home loan. If interest rates are lowered low enough, the mortgage reduction policy is the only part of his plan we may need. We may not need that policy either if the banks and investors come to realize that marking down the mortgage is in their best interest, tax and capital wise.

Let me explain the capital advantage. When a bank has a non-performing asset the value of the asset decreases more than if the bank discounts the mortgage. After discounting the asset's value, the asset becomes a performing asset again and is worth twice as much. more info. americansolutions.com search "happyashell"

Mar 08 04:19 AM

[Aristophanes:]

On Mar 07 03:55 AM JohnL wrote:

> I provided multiple references showing that deposit banking and full-reserve
> banking were established by legal precedent in classical Greek and
> Roman law. Are you disputing them?

They do not mean what you are implying. You are using a modenr term to describe commerce in another era.

Roman banking was divided into 2 sectors:

1) The merchant banking sector, small, partially regulated (guild and apprenticeship) and preoccupied with trade commerce (and slavery). These would be closest to the modern equivalent, but they were tiny fraction of the capital allocation in society as a whole. They made the vast majority of their money on money changing.

2) The nobility. Probably over 90% of the capital in Roman society resided with this group of patricians (larger for Greece). Their capital was deposited mostly a means of preservation and the mutual understanding of all of their class created systemic stability. They leveraged their capital in different ways, but usually not via lending. They would invest it alongside money from the treasury for the ransacking of foreign lands (tribute) or tax farming of subservient provinces. They would buy legions or collectors and would barter, trade and sell political and religious offices amongst themselves for these purposes.

Roman finance was about coinage being printed by the treasury in Rome or authorized centres, then distributed by the military or through contractors (rife with kickbacks) building public works, like baths, colosseums, or forums. Redistribution was done by way of patrician to plebeian. Taxes went up to the nobility. Tribute from conquest was another means to pay the troops and the loyal and enrich the upper classes.

Money supply growth was sporadic and highly centralized as coinage was the only permissible currency. Despite the near ubiquity of coinage and the Roman legal system, barter was very common, perhaps in local transactions more than currency transactions. Furthermore implicit in virtually ever transaction involving debt was the assertion that property (and labour was a form of property) was the true collateral.

The concentration of what we would call "banking" amongst the aristocracy was so dominant the Empire rose and fell with this class and their use of wealth. Rome suffered numbers of financial crises caused by inflation as the money supply almost always failed to keep up with demand; the aristocracy and the Emperor's siphoning prevented real returns on investment. There were no private notes or alternative systems of capital formation and allocation. It doesn't matter what you want to call it in a modern sense. The Ancient world had cultural and structural systems that prevented the full leverage of monetary capital, in large part because the underlying collateral (real estate, servitude labour, commodity goods) always held more intrinsic value than the returns investment. The risk (end of patrimony, eventual slavery) far outweighed the rewards. Rome created a capital system in its coinage, but then forced the supply towards an aristocracy, eventually leading to cycles of inflation and civil unrest.

This would lead to the eventual feudalization of the late Roman Empire, also the defining characteristic of the Middle Ages.

> I provided multiple references showing examples of full-reserve banking
> practiced in Europe. Are you disputing them?

No. Of course not. They coincide with an era of autocratic and centralized political rule that favoured the hoarding of capital amongst an aristocracy and especially the royalty. The late Roman feudal system endured in large part until the early stages of the Industrial Revolution, and the French and American Revolutions.



> How does using gold as money lower the saver’s risk tolerance or
> raise his liquidity preference?
>
> How can an unwillingness to lend be attributed to commodity-backed
> money or full-reserve banking?
>
> Requiring loan collateral does not result from full-reserve banking,
> but from poor credit risk. Most loans in our fractional-reserve system
> require collateral, do they not?

The biggest growth sectors do not, actually. The growth of non-secured debt has been much larger than secured.

> How does full-reserve lending make worse the consequences of debt
> default for the borrower?
>
> Investment risk-taking by borrowers increased primarily due to changes
> in bankruptcy laws.
>
> How does full-reserve banking cause corruption?
>
> Full-reserve banking eliminates systemic failures caused by bank
> panics and debt deflation.

Possibly. A bank run is the Achilles Heel of fractional reserve banking. As with

> Increasing the supply of “credit” or fiat currency produces only
> the illusion of an increase in available capital. This leads to entrepreneurial
> error.

"Entrepreneurial error?" Where on earth did you dig up that term?

Real capital is working capital. If the output from a hypothetical full reserve loan is the same as a loan from fractional reserves then the latter system has done more with less.

That's called efficiency.

You seem to be implying that fractional reserves increase bad loans.

> Commodities generally increase at the same rate as the population.

No, they do not. They are sporadic. Any historian who has studied famine will tell you that.

In any case, it's the distribution that matters. Try rebuilding Germany after WW1 when the Treaty of Versailles is sucking your economic lifeblood.

> With regard to your latest comment, you talked a lot about the extensive
> use of barter. I’m not defending barter systems, I’m not proposing
> that we go back to them and I’m not convinced that using gold-backed
> money leads an economy back to them. I'm afraid you’ve lost me on
> that one.

What I said was that fractional reserve banking allows for greater capital access as a means of getting away from barter systems prevalent in the developing world (actually, the developing world is far more likely to fall back on the US$ before barter).

When you have the intense, medieval capital hoarding of primogeniture in developing societies the banking system is controlled by those with the most deposits. They insist on no lending to lower castes, etc. They do not lend out their capital save to cronies with whom they have other forms of leverage.

In order to break that cycle capital must be leveraged even more. Fractional reserve banking came about at precisely the same time as the early Industrial Revolution, spurring far greater leverage and innovation that would have been possible under the Ancien Regime politics of the landed aristocracy.

> You state “There has never been a full deposit system that survived
> into modern times because the systems cracked under the stress of
> capital expansion, vastly outrunning the input of depositors.”<br/>...
>
> First, I never claimed that deposit banking or full-reserve lending
> survived from ancient times to the present. In fact, I understand
> that most all banking ceased during the Middle Ages.
>
> Second, are you saying that growth of tangible wealth outpaced that
> of the money stock, leading to deflation? I don’t think that is historically
> accurate. There are numerous examples of inflation caused by credit
> expansions in early fractional-reserve economies. Among them: the
> inflation in Florence that preceded the banking collapse of 1341-46
> and the inflationary policies of the Medici bank from the 1460s until
> its collapse in the 1490s. There were deflations and collapses, but
> I think they were all preceded by credit inflations that could not
> be sustained.

Rome and Greece suffered terrible inflations, yet you are saying their systems were full reserve.

It doesn't matter the system. What matters is the distribution of capital. That is politics, not banking structures.

In general, credit explosions have come about from massive de-regulations (or in areas of zero regulation, such as anywhere near a gold rush).

All of the examples you give are from regimes where the political context is of a dynamic merchant class from small city states striving to prosper through capital innovation, spurred on by the competition from the Islamic world in their Mediterranean sphere.

A century later the highly centralized Ancien Regime nations reassert themselves with feudal fury (the 30 Years War, and almost any conflict up to the French Revolution).

> And can you demonstrate that deposit banking caused this “stress”
> which led the “system” to “crack?” As a counter example, the Dutch
> flourished during the period when their banking system was dominated
> by the Bank of Amsterdam – from 1609 until after 1800. This bank,
> as was described appreciatively by Adam Smith and David Hume among
> others, operated as a full-reserve lender until at least the late
> 1700s. In 1699, the French ambassador described the city: “Amsterdam
> is without any doubt the foremost in greatness, wealth and the extent
> of her trade. There are few cities even in Europe to equal her in
> the two latter respects; her commerce stretches over both halves
> of the globe, and her wealth is so great that during the war she
> supplied as much as fifty millions a year if not more.” Their full-reserve
> banking system does not seem to have been a problem.

Of course the Dutch bank fluorished!

Look who was militaristically and dynastically opposing the Dutch? The Hapsburg Spanish.

This does not mean Amsterdam flourished because of its banking concept. It fluorished because the Protestants saw it as a place to invest and hold wealth that was safe and secure once the Spanish yoke had been defeated (except the Belgian part).

There were extraneous reasons other than their banking deposit system.

> -- You have it entirely backwards when you assert that the state
> "participated" in its formation. These merchants were running away
> from the constraints of the state. --
>
> Did not the state provide the banks their charters and licenses?

Primarily after the fact. Generally when you're asking to form a bank to issue notes, you've already got the capital. You're probably already doing the same activity but in a merchant or guild context. At that point, guess who sees you as a threat? The aristocracy. The state. They hated the merchant class getting leverage they could not. They hated the fact that spice and tea were worth more than a farm in Coventry. Their entire economic structure was founded on real estate and patrimony and they reacted viscerally and legislatively against merchants who sought to remove the economic shackles and free up capital..

> Did they not set up and enforce the laws which permitted fractional-reserve
> banking to flourish, counter to legal precedent handed down from
> Greek and Roman law?

Later. For the most part as I have read the private banking system kind of ran amok and the state was playing catch-up to the capital innovations (like now). I am thinking Hudson's Bay (pretty much ran a bank), British East India, etc. Read a history of the British Liberal Party.

The socio-economic history of the Industrial Revolution is largely about creating a working then middle class by way of the extension of capital; removing the requirement (that old patrician/plebian thing) that investment in the livelihood of the state is the work of an aristocracy and royalty.

Without that critical leverage of capital efficiency (and risk, I'll grant that) from fractional reserve banking, we'd be at about 1830 right now in our development.

>And I think state participation can be seen
> directly when the government entered the banking business itself.
> Examples: the Taula de Canvi (Barcelona’s Bank of Deposit) in the
> 15th century; the Bank of Stockholm in 1668; the Bank of England
> in 1694, which was effectively a government bank.
>
> -- Historically, fractional reserve banking is an unqualified success.
> The history of Western progress is absolutely linked with this evolution.
> --
>
> The list of inflations, deflations, bank failures and disruptions
> of commerce under fractional-reserve banking is as long as your arm.

And so? The list of failures from any socio-economic system is just as long. That proves nothing. You are asserting a cause where there. is no proof that the structure is intrinsically the problem. From my historical perspective, universal constructs that are thrown out as laws or truths are far more centralizing and damaging to liberty and prosperity for the majority than the evolution of a banking structure. Full reserve banking is an ideological concept that did not evolve to meet a need (at least not yet). I doubt it can ever come about as there could be no practical way to feasibly enact it. You'd either have to force lending or stop loaning and play catch up. And get the entire rest of the world to go along. Centralizing ideas like this frighten me more than what is going on right now.

Mar 08 07:57 PM

[JohnL:]

Aristophanes,

I need to end our little debate here. You are not convincing me and I'm sure the feeling is mutual. I do appreciate your time; you provided some interesting historical commentary. That said, you refused to rebut my specifc arguments and you provided no references for the historical claims you made. When I made theoretical arguments, rather than countering with your own logic, you just said that I was stuck in ideology. Well, Austrian Economics is no more an ideology than Keynesianism, Monetarism or any of the other schools of economic thought. Frankly, I thought most of what you said was from some leftist monologue rather than an economic argument. I'm afraid the impasse is just too wide. Too bad, really.

Take care.
JohnL

Mar 09 01:51 AM